What is an Adjustable Rate Mortgage?

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Contributor, Benzinga
September 1, 2021

After the 2008 financial crisis, there were a lot of scapegoats touted by the media as the cause(s) of the meltdown. Among the most frequently named suspects were adjustable-rate mortgages, also known as ARMs. It’s not a stretch of the imagination to say ARMs became almost like a four-letter word in the television and online news coverage of the crisis. Although it’s impossible to deny that a high number of ARMs went into default before and during the crisis, it’s also true that adjustable-rate mortgages can be a valuable tool for savvy borrowers looking to build wealth through buying property. 

What is an Adjustable Rate Mortgage?

Every mortgage has an annual percentage rate or APR, which is the amount of interest the mortgage lender charges the borrower for making the loan. Borrowers pay back the loan principal plus interest, which is how the lender makes money on the loan. For a long time, the APR on home loans was mostly set in stone, which guaranteed profits for the lender and stability for the buyer. However, as homes became more expensive and people began moving more frequently, the need arose for a more flexible financing option. This is where adjustable-rate mortgages came into the picture. 

An adjustable-rate mortgage is a mortgage where the interest rate can change at various points throughout the life of the loan. They differ from traditional fixed mortgages, which get their name from the fact that the interest rate remains the same for the entire loan term. The base APR of an ARM is usually tied to a public benchmark, such as treasury bills or a particular market index. Then the APR for the mortgage is set at a certain percentage above that benchmark. Afterward, the APR can go up (or down, but usually up) based on that benchmark’s performance in the market. 

There is no maximum legal number of times the APR on an adjustable-rate mortgage can change. It all depends on the agreement between the lender and the borrower, although the lender’s say usually carries the most weight because it’s the one choosing to lend the money or not. With that said, the number of times the APR can change during the life of the loan will be specified in the mortgage contract. Some mortgages call for the APR to change multiple times in the same year, whereas others might adjust the APR over longer periods — usually 5 to 7 years. 

This is why you must read everything you sign quite carefully. If your bank (or state) only allows a certain number of rate changes, that’s great. If not, you could be in for a bumpy ride.

The Benefits of an ARM

As discussed in the opening section ARMs got a very bad rap after the 2008 financial crisis. This has led to the widespread misperception that ARMs are debt traps designed by predatory lenders looking to exploit consumers. However, the reality is that there are a number of potential benefits to consumers in taking out ARMs. 

One of the main benefits to consumers is that since the introductory APR is usually lower, they can borrow a lot more money than they could with a traditional fixed-rate mortgage. What this means is that ARMs allow borrowers to buy a lot more house with the same down payment than they could with a fixed-rate mortgage. Depending on the location of the house and how hot the local market is, there is even a chance that the house will appreciate in value enough to cancel out the rate adjustment. 

Additionally, borrowers with ARMs can plan for rate increases because they will be scheduled in the mortgage. That means they may have to refinance the property more often than fixed-rate mortgage holders, but with current rates at historic lows, refinancing is not a difficult proposition. 

In spite of what you may have heard, ARMs can be very easy to understand and manage. The amount of any APR increase is capped in accordance with applicable state lending regulations where the mortgage is made. This is in addition to the fact that both the increase (or formula for the increase) and the number of times the rate will adjust is also specified in the mortgage.  So for example, a 5/5 ARM means the borrower will have a fixed rate for 5 years before the interest rate adjusts, and it will adjust every 5 years after that for the term of the mortgage. 

Who Needs an Adjustable Rate Mortgage?

There are several types of borrowers who would benefit from adjustable rate mortgages. Borrowers who move frequently for their jobs but still want to take advantage of the tax benefits that come with homeownership are great candidates for adjustable-rate mortgages. There is no need for them to take out a fixed mortgage at a higher interest rate on a house they know they are going to sell in 2 or 3 years when they get their next job. 

If you’re the sort of person who follows the job every few years, don’t be afraid to grab an ARM. This is a good choice because you keep costs down for a few years before you move on. However, you should prepare to refinance if you finally decide to settle down. Also, if you move on and keep the home as a rental property, you definitely want to refinance while you still can.

The same thing holds true for borrowers who are fortunate enough to be in careers where they are experiencing sustained upward mobility. If you work in a booming field or a hot startup and you’re positive your income will be increasing in the coming years, taking advantage of the low interest rates offered by ARMs and continually refinancing before the rate jump will allow you to pay off your home faster.  

Home flippers also prefer ARMs because the lower APR allows them to buy nicer and larger properties for less money. The logic here is that the larger and nicer the property they buy is, the more money they can flip it for after renovations. Home flippers are not deterred by the prospect of a rate increase because they plan to sell the property long before the increase kicks in. 

Lastly, borrowers who wish to pay their mortgages off as quickly as possible may be well served by using ARMs. The lower interest rate allows them to pay off the loan balance more quickly with the proviso that the borrower keeps refinancing the loan to continually secure the lowest interest rate possible. If you fit any of the above borrower profiles, an ARM may be exactly what you need to get the most bang for your buck!

Benzinga’s Best Mortgage Lenders

Regardless of the reason you may be considering an ARM, it’s always best to shop around. Different lenders have different loans, and if you’re not aware of all your options, you may end up paying more money than you have to. If you’d like to learn more about which mortgage lender may have the best terms for your situation, consult Benzinga’s list of best mortgage lenders below.

The Last Word on Adjustable Rate Mortgages

When used properly, ARMs can be a valuable tool in helping consumers build wealth through real estate. On the other hand, buyers who don't fully understand how to navigate the complexities of ARMs could find themselves unable to make their mortgage payments. At the end of the day, the final verdict on whether or not an ARM is right for you boils down to your individual situation and how well you can manage your finances. 

FAQ’S

Q

Why would you take out an adjustable-rate mortgage?

A

There are several situations in which it might make sense for you to take out an adjustable-rate mortgage. An ARM could be an astute financial move if you find yourself in the following situations:

  • You move frequently but don’t want to rent because you prefer the tax benefits of home ownership
  • You are a home flipper who wants to buy the best possible house with the lowest possible monthly payment before you flip the house
  • You are making a lot of money and you want to use it to pay your house off as quickly as possible by taking advantage of the low interest rate offered by ARMs
Q

Are adjustable-rate mortgages bad?

A

Adjustable-rate mortgages are neither good nor bad. In fact, they offer many benefits to astute borrowers who understand them and know how to manage the mortgage terms. However, an ARM can easily go south for borrowers who are not prepared for APR increases that drive the payments up. The key is to always be out in front of the rate increase.

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