The housing market always goes through its ups and downs. During the pandemic, homeowners and homebuyers alike were able to benefit from record-low interest rates. Now, as inflation continues to soar and the Federal Reserve raises rates to offset the climb, the market is cooling down.
The combination of higher home prices and rising interest rates are forcing many would-be homebuyers out of the market. While conventional fixed-rate mortgages reign king during periods of low rates, other home loan options shine in uncertain markets. One of these loans is an adjustable-rate mortgage or ARM.
With the ability to lock in lower introductory rates, ARMs are making a comeback. Is an adjustable-rate mortgage the right solution for you?
Fixed-Rate vs. Adjustable-Rate Mortgages
While several homebuying options are available today, two stand out as the most popular – Fixed-Rate and Adjustable-Rate Mortgages.
- Fixed-Rate Mortgages: A conventional fixed-rate mortgage is one of the most popular types of home loans. As the name implies, your interest rate is fixed or locked in throughout the life of your loan. This feature makes it easier to budget long-term since the principal and interest portion of your payments will always be the same.
- Adjustable-Rate Mortgages: An adjustable-rate mortgage (ARM) differs in that your interest rate can adjust during the term of your loan. Typically, ARMs have lower introductory periods with fixed interest rates. Then, the rate will change after a designated period according to the current market rates.
Fixed-rate mortgages are excellent options when interest rates are low. When interest rates are climbing, or the market is fluctuating rapidly, an ARM becomes more attractive.
How Does an ARM Work?
Upon researching adjustable-rate mortgages, you’ll first notice a difference in their terms. For instance, you may see ARM terms listed as 3/1, 5/1, or 7/1. The first number defines the introductory period, while the second pertains to how often the rate can adjust.
- Introductory Period: During this initial phase, your interest rate will usually be fixed, meaning your payment will not change.
- Adjustment Period: Your mortgage rate can adjust after your introductory period ends. If rates went up since you originally financed your loan, your mortgage rate would likely increase. If rates declined, your rate would go down. The biggest obstacle people have with ARMs is the adjustment period. Budgeting can be difficult when your mortgage payment fluctuates each year.
Using the 5/1 term as an example, the lower-rate introductory period will be for five years. Then, your mortgage rate can adjust yearly for the remainder of the loan.
Pros & Cons of ARMs
Before considering an adjustable-rate mortgage, it’s important to understand all the perks and downsides.
- With lower introductory rates than most home loan options – homeownership becomes more achievable for many.
- The lower-rate introductory period allows you to save money each month to put toward other financial goals, such as building an emergency fund or boosting your retirement accounts. Or you could put the monthly savings toward the principal balance of your loan and build equity quicker.
- If rates decline, you will automatically benefit when your rate adjusts next. With a fixed-rate mortgage, you would have to refinance your loan and pay hefty closing costs to take advantage of lower rates.
- Lower introductory rates allow many homebuyers to buy homes they might not be able to afford otherwise.
- When the initial introductory period ends, your rate can fluctuate. This characteristic makes it more difficult to budget when your mortgage payment keeps changing.
- If rates continue to rise, you might end up with a payment you can no longer afford.
- The application process of ARMs can be more complex than traditional mortgages. They often come with additional rules, fees, and structures that will vary by lender.
Why Would You Choose an ARM?
While adjustable-rate mortgages aren’t for everyone, they offer unique benefits to the right homebuyers.
- Limited Stay: If you know you’ll only be living in an area for a certain number of years, an ARM could be the perfect type of loan. It allows you to take advantage of very low introductory rates and build equity quickly. Then, before your rate adjusts, you sell the home and move. This is a common strategy among military families when they know they will only be stationed in a location for a few years. It allows them to build equity and profit off the sale of the home.
- Starter Home: Similar to the Limited Stay, many young people purchase their first home knowing they won’t be in it forever. An ARM allows you to take advantage of the low introductory rates and build equity. Then, before the rates adjust, you can sell the property and use that equity to purchase your forever home.
- Fixer-Uppers: Many investors will buy fixer-upper homes, live in them for a couple of years while overhauling them, and then sell them for a profit. ARMs allow you to build equity and pay less interest while you work on your investment.
- Equity Builders: Those in this category focus on buying homes to build equity to use for their next home purchase. They continue this cycle of buying, building equity, and selling to build wealth. Since they are not long-term homeowners, they benefit from the low introductory rates of ARM products.
We’re Here to Help!
It’s important to remember that buying a home is a significant financial investment. There will always be pros and cons present to whatever type of loan you choose. Our home loan experts are here to help you discover which loan option will work best for your specific needs.
Please stop by any of our convenient branch locations or call (949) 588-9400 to schedule an appointment to discuss your future homebuying plans.
Each individual’s financial situation is unique and readers are encouraged to contact the Credit Union when seeking financial advice on the products and services discussed. This article is for educational purposes only; the authors assume no legal responsibility for the completeness or accuracy of the contents.
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