Interest rates are still historically low, making it attractive to get a 30-year fixed loan with payments that never go up or down the entire 360 months. But there are still loan products out there that can give homebuyers and renovators an even lower interest rate that might help them in their situation – and it’s called an adjustable-rate mortgage (ARM).
ARMs got a bad reputation because many people blame them for the mortgage crisis, says Brenda Jenkins, senior loan specialist at Interlinc Renovation Lending in Franklin, Tenn.
“But an ARM is all about how long you are going to be in your home and what you are trying to achieve?” she explains.
An example of one of her clients that an ARM helped was a single woman who had been in sales for 15 years. However, she took a year off to take care of her terminally ill father. She had gone back to work in the same field for 1 ½ years before she applied for the mortgage. Most lenders need to see two years of consistent employment in the same field before signing over on a loan.
“This woman was being penalized for taking care of her dad,” Jenkins says.
In January 2015, she was able to get her qualified for an FHA ARM loan and locked her payment at 3 percent which made her payment pretty low. Sometimes because of the low payment and low interest rate, it’s easier to get someone qualified that wouldn’t have been approved for a fixed loan — FHA or conventional.
“There was no way she could have ever gotten a fixed FHA loan without paying $8,000 on points,” she said.
With nine months into the ARM, her client decided to refinance into a conventional loan and out of her mortgage insurance payments, saving her even more money.
A lot of developers and house flippers use ARMs because they won’t be needing the loan for very long. It makes sense, Jenkins says.
ARMs are 30-year loans, which many people don’t realize, she adds. The initial interest rate is only fixed for a certain period of time such as 3, 5, 7 or 10 years. Then, the rate is adjusted to go up or down. Lenders use the index and the margin to figure out how to adjust your rate.
According to the Consumer Financial Protection Bureau, the index is a benchmark interest rate that changes by what the general market conditions is doing. Indexes are chosen by the lender, and one of the most popular one used is the one-year LIBOR, the London Inter-Bank Offer Rate. But there are exceptions to that rule.
“If you are leaning toward an ARM, you really need to do some research on indexes,” Jenkins says. “And if you can have a choice of what the index will be, then you should look into that.”
With FHA loans, you don’t get a choice because they are based on the Treasury Security, she says.
The margin is set by the lender when you apply for the loan, and this figure won’t change after closing. That margin can vary from lender to lender, and it’s possible to negotiate the margin just like the rate on a fixed-rate mortgage. The good thing is that most ARMs also have caps that limit how far the rate can jump even if the index has changed by more.
ARMs can get quite confusing to people with caps and periodic caps, carryovers and negative amortization, Jenkins says. So, finding a lender who understands these types of loans and has done many of them can only help a borrower’s situation.
Pros of an Adjustable Rate Mortgage
Lower interest rate in the beginning: The rate can be one percent lower or even more than that compared to fixed rate mortgages. With a lower rate, your payments are lower. That means you might be able to qualify for an ARM when you couldn’t qualify for other mortgages. You also might be able to buy a bigger or nicer home because your rate is less.
Appeals to the more mobile borrower: If you need to move away for your job or want to sell the house before the introductory period of your ARM ends, then you have enjoyed a lower rate without having to refinance to a fixed-rate mortgage or dealing with the adjustable rate going higher.
Need the loan for a short period: If you are a house flipper or someone who is developing a rental house, then an ARM could be a good choice. The rate is low helping you to have low payments while the remodeling takes place.
Fixed rate for certain period: Depending on the type of ARM you select, the fixed rate continues throughout that time from 3-10 years, usually.
Cons of an Adjustable Rate Mortgage
Scary not knowing: Your interest rate rises when the market rates increase. Sometimes the stress of not knowing is too much for some people to handle.
Refinancing costs: If you plan on only have an ARM for a while and hope to refinance, remember that refinancing also has closing costs and other fees that can add up.
Budgeting becomes more difficult: Since you won’t know how much your monthly payment will be if your interest rate fluctuates regularly, it’s going to be a little tougher to figure out your finances.
First rate increase could be big: The annual cap rules most often don’t apply to the first increase after the introductory rate ends. So, it can be larger.
“There are a lot of ARMs out there, and the price is pretty good right now. Plus remember that most people usually don’t live in their home more than 10 years, so an ARM might be a good choice if that is your situation,” Jenkins says.