Is It Ever a Good Idea to Opt for an Adjustable Rate Mortgage?
Prospective homeowners face a crucial decision when choosing between fixed-rate mortgages (FRMs) and adjustable-rate mortgages (ARMs). While ARMs have a controversial reputation following the 2008 housing crisis, financial experts suggest there are specific scenarios where they might be the right choice for certain borrowers. Here's what you should know about how adjustable-rate mortgages work, and when they might be the right call for you.
When an adjustable rate mortgage could make sense
The primary appeal of ARMs lies in their lower initial interest rates compared to fixed-rate mortgages. These introductory rates typically last between three and 10 years, offering significant savings during the early years of homeownership. Chad Gammon, CFP and owner of Custom Fit Financial, explains that this lower initial rate can be particularly advantageous for homeowners who anticipate either income growth or falling interest rates during the loan period.
However, Gammon emphasizes the importance of understanding the risks: "Once that introductory interest rate period ends, the rate could adjust upwards." A good example would be ARMs that were taken out pre-2020. He stresses that ARMs are more complex financial instruments, making it crucial for borrowers to fully comprehend the implications of extending beyond the fixed-rate period.
Short-term homeownership
For those not planning to put down long-term roots, ARMs can offer substantial benefits. Doug Carey, CFA and founder of WealthTrace, points out that many homeowners stay in their properties for less than seven years. "If the plan is to sell the home before the rate adjusts," Carey explains, "the lower initial rate gives them a financial benefit." This strategy allows homeowners to capitalize on lower rates during their planned stay while avoiding potential rate increases down the line.
Affordability in high-cost markets
In expensive housing markets, ARMs can make homeownership more accessible. The lower initial payments can help buyers qualify for homes that might otherwise be out of reach with a traditional fixed-rate mortgage. While this approach carries future rate adjustment risks, it can be a calculated risk for those expecting income growth or planning to refinance later.
Strategic refinancing opportunities
Many ARM borrowers plan to refinance before their adjustable period begins. Carey highlights this as a potential money-saving strategy: "Take advantage of low rates during the initial period, then refinance at a favorable time to either lock in a lower fixed rate or continue with another ARM." This approach requires careful timing and market awareness but can result in significant long-term savings.
How to decide if an ARM is the right call for you
Andre Small, Founder & Financial Planner at A Small Investment, LLC, shares a practical example of when ARMs make sense. He describes working with a client whose career required frequent relocation, but who still wanted to build real estate equity. In this case, an ARM provided the flexibility to "pay down debts now, as well as maintain manageable debt levels for a predetermined time frame."
When considering an ARM, potential borrowers should evaluate several factors:
Expected length of homeownership
Career trajectory and potential income growth
Current market conditions and rate trends
Personal risk tolerance
Long-term financial goals
While ARMs can offer significant advantages in certain circumstances, they require careful consideration of the risks and a clear understanding of the loan terms.
The bottom line
Adjustable-rate mortgages can be a viable option for some borrowers, but the key lies in having a clear exit strategy. If you can take advantage of the lower rates to make more payments to principal, ARMs can be a savvy move. But if you need an ARM to afford a house, you are taking on a significant risk. As with any major financial decision, consulting with financial professionals who can evaluate your specific situation is crucial before committing to an ARM.