Reader question: “When does it make sense to use an ARM loan, compared to a fixed loan? When should a first-time home buyer consider using an adjustable rate mortgage, and when should it be avoided? Is there a rule of thumb for the length of time you are planning to keep the house?”
The adjustable-rate mortgage, or ARM, developed a bad reputation in the wake of the housing crisis. These loans typically offer much lower interest rates during the first few years, when compared to fixed-rate mortgages (FRMs). That’s the primary reason why people use them. But they also bring a lot of uncertainty down the road, in the form of rate adjustments. Here’s what borrowers need to know before choosing an ARM over an FRM.
When It Makes Sense to Use an ARM Loan
So, when is it a good idea to use an ARM loan instead of a standard fixed-rate mortgage? The only time I recommend using one is when you know you’re only going to be in the house for a few years. For example, somebody who is in the military, or somebody with a job transfer where they’ll only be in an area for two or three years, might be able to use the adjustable-rate mortgage to save money in the short term. But things get risky when you use an ARM for a long-term stay, beyond the first adjustment period.
To understand when it makes sense to use an ARM loan, you first have to understand (A) how they work and (B) how they compare to fixed-rate mortgage loans where interest rates are concerned. So let’s talk about that.
‘Hybrid’ Products Offer Benefits in the Short Term
Most of the ARMs in use today are actually “hybrid” loans. Here’s how the Federal Reserve defines a hybrid: “The interest rate is fixed for the first few years of these loans — for example, for 5 years in a 5/1 ARM. After that, the rate may adjust annually (the 1 in the 5/1 example), until the loan is paid off.” So there is some degree of certainty in the short term, but less certainty over the long haul.
ARM loans typically have lower interest rates during the initial fixed phase than a traditional fixed mortgage. So if you buy a house with an adjustable product that has a lower interest rate than its fixed counterpart, and you sell the house within a few years before the loan begins to adjust, you could save money while avoiding the risk of an interest hike. This is the type of scenario where it might make sense to use an ARM.
Some people “roll the dice” by using adjustable mortgage products with the intention of refinancing before the adjustment period. Sometimes this works out — other times it does not.
For example, consider the massive decline in home prices that occurred across the United States, from 2007 – 2011. Before the market tanked, many home buyers chose to use ARM loans in order to save money during the first few years, and they planned to refinance after the introductory period to secure a more stable fixed rate. But for many homeowners, their home values dropped to the point that they had no equity left. In this kind of scenario, it’s very difficult to refinance out of an adjustable mortgage. You get stuck with it.
So there are certain risks to consider when using an ARM loan. It’s not always a good idea to use one. But if you know what you’re doing, you can use this type of loan smartly and safely, while saving money in the process.