Rising interest rates and home prices are making adjustable rate mortgages (ARMs) more attractive to potential homeowners nowadays. This can be mainly attributed to the lower interest rates they offer in comparison to fixed mortgages. While ARMs may advertise lower interest rates initially, they can also be riskier for borrowers due to the uncertainty that comes with them.
Fixed vs. Adjustable Rate Mortgages
With fixed-rate mortgages, you pay the same fixed interest rate over the entire life of the loan. Whereas with adjustable rate mortgages, the interest rate will change after set intervals and may go up or down over time. ARMs typically offer initial rates that are around 1% cheaper than fixed-rate loans. These rates are fixed during an introductory period which usually spans five or ten years. After that period, the interest rate will be adjusted at set intervals based on the current market rates. This leads to the possibility of the rate rising significantly, making it more difficult for borrowers to keep up with payments. This is especially true for those earning the same income but having monthly payments increase.
ARM Mortgages
ARM mortgages are advertised as a set of numbers such as 5/1. This indicates that the rate is fixed for an initial period of 5 years, then the rate adjusts every year after that. Similarly, a 7/6 ARM would mean a fixed rate for the first 7 years and adjustments every 6 months after.
The main risks when it comes to adjustable-rate mortgages have been partially addressed to make them much safer and more transparent. Limits have been placed on how much interest rates can increase throughout the lifetime of the loan and during different payment periods. For example, the increase in interest rate cannot exceed 1% per year and not exceed 5% throughout the entirety of the loan period. Also, borrowers can opt to switch over from an ARM to a fixed-rate mortgage for a fee.
Making an informed decision
While adjustable-rate mortgages can be useful in some scenarios, it is essential for borrowers to understand exactly what they are getting themselves into. This means not being misled by the lower starting interest rates and being prepared for unexpected rate hikes after the introductory period is over. Odds are, if you can’t afford to pay the slightly higher fixed rates, then it may be best to avoid the risks associated with adjustable-rate mortgages.
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