When is an adjustable-rate mortgage a good idea?

With home ownership being such a pricey proposition, more than a few buyers may need to find alternative ways to get into a property. In this environment, adjustable-rate mortgages (ARMs), which offer a lower introductory interest rate than traditional fixed-rate mortgages, may be an appealing option.

But there are pros and cons to keep in mind when considering ARMs, including the fact that the interest rate doesn’t remain low forever, and when it finally adjusts, your monthly payments may increase and even become prohibitively expensive.  

What is an adjustable-rate mortgage, and how does it work? 

An adjustable-rate mortgage begins with an initial introductory interest rate and after the promotional period ends, the rate adjusts either on a monthly or yearly basis in tandem with market fluctuations. The introductory rate may last for as little as six months or as long as 10 years, and it is often far lower than rates available on 30-year fixed-rate mortgage loans.

“An adjustable-rate mortgage is a mortgage product based on a 30-year repayment schedule, but the interest rate is not permanently fixed for the entire 30 years,” says Brian McCauley, a mortgage officer with Fairway Independent Mortgage Corporation—The McCauley Team, a Texas-based lending team. “The most common ARM options are a five-, seven-, and 10-year ARMs… The shorter the time frame you choose, the lower and more competitive the interest rate, so you want to choose wisely to maximize as much savings as you can without putting yourself at high risk.”

There are also various caps in place regarding how much ARM interest rates and the resulting monthly mortgage payments can increase, according to the Consumer Financial Protection Bureau (CFPB). The caps cover the initial rate hike once the introductory period ends, as well as subsequent rate adjustments, and adjustments over the lifetime of the loan.

The initial rate increase after the intro period ends is typically between 2% to 5%, according to the CFPB. Subsequent rate adjustments, meanwhile, are often around 2%. And over the life of the loan, the rate generally shouldn’t increase more than 5% higher than your initial rate.

Pros of adjustable rates 

While there are some risks involved, there are also many benefits when using ARMs, particularly for short-term home buyers who may move before the interest rate resets, those planning to refinance their mortgage down the road, and for buyers with a strong and consistently reliable cash flow. 

Low initial interest rates

For first-time home buyers who are finding fixed-interest rate mortgages prohibitive amid the current environment, ARMs offer a valuable way to make home ownership more affordable.  As of January, ARM rates are between 5.5% and 6.16%, according to Bankrate, while the rates on 30-year fixed mortgages start around 6.6%.

“In this high-interest rate environment, ARMs can be a way to start homeownership at a lower interest rate with the hope of refinancing if interest rates come down prior to when the five-, seven- or 10-year initial fixed period ends,” says Jack Kammer, vice president of mortgage lending for the national mortgage originator OriginPoint.

You can put more toward principal

Because the monthly mortgage payment starts out so much lower with an ARM, home buyers may have the opportunity to direct some of that saved money toward paying down the loan principal more aggressively.