Course 8 – Unit 1: Is an Adjustable Rate Mortgage Right for You?

Is An Adjustable-Rate Mortgage Right For You?

There is a perfect mortgage product for every mortgage borrower. And, for some, that perfect product is the adjustable-rate mortgage (ARM). An ARM is a mortgage which offers introductory mortgage rates — known as “teaser rates” — for up to the first 10 years of a loan. After the teaser period ends, the loan’s mortgage rate adjusts annually to reflect current market conditions. In exchange for accepting a mortgage rate that can change, banks offer low mortgage rates during the initial, non-adjusting period your loan. The mortgage rate on a 5-year ARM, for example, will typically be close to 100 basis points (1.00%) less than the rate for a comparable 30-year fixed rate loan.

So, why might you choose an adjustable-rate mortgage over a fixed? Well, if you’re a first-time home buyer and you don’t plan to make your home a “forever” one, choosing an ARM over a fixed-rate loan can yield huge cash savings. The same thing applies for buyers who frequently move. There is no sense paying for a 30-year rate if you’re going to move in six. Or, refinancing your home to a 30-year loan if you’re going to sell or refinance again soon anyway.

So, which is better — ARM or fixed? Read below and see what you think.

When you’re shopping for a mortgage, the difference in mortgage rates between an adjustable-rate mortgage and a fixed-rate mortgage is known as the “spread.” The spread is your incentive for using an adjustable-rate mortgage instead of a fixed. The bigger the spread, the more attractive the ARM will look. For example, if you’re choosing between a 10-year adjustable-rate mortgage and a 30-year fixed, and the difference in mortgage rate is 12.5 basis points (0.125%), you may feel that there is little reason to accept the risk of an adjustable-rate loan.

However, if the spread widened to 50 basis points (0.50%) or more, your mind may start to change. In general, the shorter your adjustable-rate mortgage’s initial teaser period, the lower its starting mortgage rate. A 7-year adjustable will have a lower starting mortgage rate than a 10-year adjustable; and a 5-year adjustable will have the lower starting mortgage rate than a 7-year adjustable. Here is a real-life example of how adjustable-rate mortgage and fixed-rate mortgage rates compare, assuming a $300,000 home loan.

The savings of an ARM can be substantial while it’s in its teaser period. After the adjustable-rate mortgage enters its adjustment period, however, savings can reduce or evaporate.

2. What is Your Time Frame In The House?

Two other factors which determine whether you should consider an ARM is the length of time you plan to live in your home and the number of years until you might conceivably attempt a home loan refinance. According to the National Association of REALTORS®, homeowners typically own property for close to seven years before selling. Older homeowners tend to own for a few years longer; younger and first-time home buyers tend to own for a few years less. This statistic, which is based on decades of data, suggests that many U.S. home buyers would be better suited to an adjustable-rate mortgage than a fixed, since a large majority of homeowners sell their home before their hypothetical adjustable-rate mortgage would ever begin to adjust.

Therefore, if you don’t consider your next home to be your “forever home” see what kind of money you might save with an adjustable-rate mortgage.