Should You Choose an Adjustable Rate Mortgage?

When it comes to fixed rate and adjustable rate (ARM) mortgages the standard personal finance advice is to always get a fixed rate mortgage. Most people opt for a 30-year fixed rate mortgage, but a 15-year fixed rate mortgage is also fairly popular. Getting a fixed rate mortgage is almost always given as the best choice because your interest rate, and thus your payments, never change. The first payment will be the same amount as the payment 15 or 30 years from now. In fact as inflation impacts the value of your money, the payment will cost you “less” in inflation-adjusted dollars.

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Why Adjustable Rate Mortgages are Typically a Risky Choice

Adjustable Rate Mortgages or ARMs are normally a risky financial choice because the interest rate on the loan can skyrocket on the borrower. Some mortgages are really hybrid ARMs that have a fixed portion for a certain period of time before adjusting a certain number of times in the future. You might be tempted by the advertised rate of 2.75% on your mortgage with an overall APR of 3.125%. When compared to a 30-year mortgage rate of 4.125% you would be saving a full percentage.

The risk comes into play when rates go up, and your ARM mortgage adjusts with the increasing rates. Suddenly your 3.125% rate is 4.125%, then 4.75%, then 5.5%. You end up paying a lot of interest and may have trouble refinancing into a fixed rate mortgage because of a lack of equity in your home.

How Variable Will ARM Rates Be?

However, when you look at the overall economy and interest rate environment the United States is in you have to wonder how variable ARM rates will really be. The Federal Reserve is doing everything it can to prop up the economy. It’s lowered interest rates to historical lows, and once that has bottomed out they have moved to other more creative methods of keeping interest rates low. Over the last 2.5 years the fully indexed rate of 1 year ARMs has remained relatively flat. Over the last year the fully indexed rate has hovered right at 3% and not spiked or dipped significantly. If the interest rate environment doesn’t change for 5 to 10 years, an ARM might be a better option for your mortgage.

How Much Would an ARM Save You in Mortgage Interest?

Will an ARM mortgage save enough interest in the short term to be worth the risk of your monthly mortgage payment going sky high? To determine whether or not an ARM would save you money in the short term, look at the total interest you would pay and compare it to a fixed rate mortgage. We’ll assume you bought a house with a $150,000 mortgage.

  • A 4.125% fixed rate 30-year mortgage will cost you $29,561.79 in interest alone in the first five years.
  • An ARM that is fixed for the first 12 months at 3.125%, and adjusts up 0.125% every year after that, will cost you $23,983.51 in interest in the first five years.
  • The difference between the two is $1,115.66 per year for the first five years.

Is the risk worth it? In this example taking the ARM makes sense in the short-term. But this is an ideal theoretical situation. What happens if interest rates jump more quickly and your rate goes beyond the fixed rate that you could have received? In that scenario a fixed rate makes sense. However, if you have a great credit score, a lot of equity in your home, and enough cash on hand to cover refinancing costs in the future, you might consider taking an ARM as long as rates remain low. At the first major indication of rates going up, you could refinance into a fixed rate mortgage. Just be sure to consider closing costs of refinancing into your interest rate savings as well.

Photo by woodleywonderworks.



Author

By , on May 21, 2013
Kevin Mulligan Kevin Mulligan is a debt reduction champion with a passion for teaching people how to budget and stay out of debt. He's building a personal finance freelance writing career and has written for RothIRA.com, Discover Bank, and many others.

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{One Comment}

  1. The risk of a skyrocketing interest rate is exactly why I chose a fixed interest rate on the house I am in the process of purchasing. I have a coworker who opted for the ARM when purchasing her home and her rate has gone up pretty substantially, as has her payment. I guess I like to play on the safe side when it comes to my home.

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