Will an Adjustable Rate Mortgage Cost an Arm and a Leg?
If you're buying a house soon, you may be mulling over the idea of getting an adjustable-rate mortgage. Or you were, until you heard about the Federal Reserve's recent decision to raise interest rates a quarter point. That likely put a chill on many homeowners' desires to have an adjustable-rate mortgage, also known as an ARM.
If you currently have an ARM, you might be in full-blown-panic mode, wondering if your interest rate is going to climb soon.
"My voicemail and email has been inundated by my clients, friends and partners all asking the same question, 'What should I do about my ARM mortgage and when?'" says Drew Grandi, a loan originator with Wintrust Mortgage in Massachusetts.
What should you do? It really depends. An ARM can be a terrific strategy for paying a mortgage, or a terrible one. Before you get one, or get rid of one, you need to think about how you want to proceed.
What Is an ARM?
It's a home loan with a fixed interest rate, usually for five years -- but after that, it can adjust every year. (That's why you'll often hear ARMs referred to as a 5/1 ARM, although you could have a fixed interest rate for a different period, like a 7/1 ARM or 10/1 ARM.)
After those five or more years are up, the interest rate can go up or down for the duration of your mortgage.
Because the interest rate could go up, it can be risky to have an adjustable rate. Nobody wants an ARM to cost them an arm and a leg.
So why get an ARM if your monthly mortgage payment can turn on you like that? Because the fixed rate for those five years or so is lower than a traditional fixed mortgage rate. It hasn't been all that much lower in recent years, of course, since all mortgage rates have been low. Still, even a percentage point can reduce a mortgage payment enough to save a homeowner thousands of dollars in the long run.
How High Can an ARM Go?
While your monthly mortgage payment can adjust every year to a higher and higher rate, there is a limit to how much financial pain you'll endure.
"There are protective caps, so the loan cannot adjust higher than the designated annual cap or lifetime overall rate cap," says Staci Titsworth, regional manager of PNC Mortgage in Pittsburgh. This is looked upon as insurance against risk.
"Most ARMs are capped so that your interest rate will not exceed more than 5 percent above your original rate," Grandi says.
That doesn't sound so bad, but it can add up. Grandi offers an example of the homeowner who has a 5/1 ARM at 3 percent on a $300,000 mortgage. That would mean you're paying $1,264.81 a month for the first five years, he says. If interest rates shot up, the most you would pay is 8 percent on that $300,000, which would mean a max monthly payment of $2,201.29, or about $936 more than your original payment.
If you are thinking about an ARM, Titsworth suggests having the loan officer run a few examples of payments, including the worst-case-scenario payment. It may be eye-opening.
What if You Have an ARM Now?
Don't panic, Grandi says. "Everyone currently in an ARM should not necessarily be hounding their mortgage expert to refinance into a fixed-rate mortgage," he says.
In fact, if you have a low-rate ARM now and you refinance into a 30-year fixed-rate mortgage, you'd likely pay around 4 percent and your monthly payment would jump a little. With that previous $300,000 ARM example, Grandi says, the homeowner's payment would go up less than $200 a month.
That may well be worth it to have the comfort of knowing you have a fixed mortgage payment. But if you're planning to move in the next couple of years, you're probably better off keeping the ARM. That's because one of the biggest factors in whether you should get an ARM is how long you plan to live in your house. Generally, if you're going to live in your home for a short time before selling it, an ARM is considered a financially shrewd move.
"I'm a big believer in ARM loans and have one now," Titsworth says. "Adjustable rate mortgages are a good option for consumers that have a shorter-term need, and also those that are comfortable with a little risk," she adds.
Who Shouldn't Get an ARM?
Do what you want, but if you'd like some general rules of thumb, there are three types of homeowners who should likely avoid an ARM.
-- First-time homebuyers. Ali Vafai, president of The Money Source, a national correspondent lender and mortgage loan servicer on New York's Long Island, says first-time homebuyers or those with little down payment should not choose ARM loans. Since rates are near historic lows today, he says it's very likely rates will be higher in five years and payments would increase after the fixed period. Even if you're not planning to stay very long, maybe you'll discover you hate moving and realize you don't want to go anywhere.
-- People on a tight budget. So you scraped up your down payment, barely, and you figure you can afford to live in a house if you pare back your budget a bit. It sure doesn't sound like you would do well if, in five years, your monthly mortgage payment shot up a couple hundred dollars a month.
-- Natural-born worriers. As has been duly noted, ARMs are a risk. Before you get an ARM, ask yourself some risk-related questions, Grandi suggests.
For instance, when you've been living in your home for two years, will you suddenly have sleepless nights because you aren't sure what your mortgage payment will be in three years?
"Do you expect continued doom and gloom for the United States' economy with unemployment increasing and inflation staying low?" Grandi asks.
In other words, if you a worrier, the ARM is probably not for you.
Titsworth agrees. She loves the ARM, though, and points out what isn't often emphasized: When your fixed rate ends and it adjusts, your monthly payment doesn't necessarily have to go higher. "It's possible the rate could drop," she says.
Still, all in all, "ARM loans are typically not the product of choice for someone that believes they will be in their home long term and wants [the] peace of mind of knowing what their payment will be," Titsworth says. "The long-term fixed rates come with less risk and therefore a higher rate."