Should you consider an adjustable rate mortgage?

For many homebuyers, the idea of an adjustable rate mortgage raises the unpleasant specter of the subprime mortgage crisis. Many people caught up in the housing crash were attracted to the lower initial rate offered by an adjustable rate mortgage, only to be blindsided when the rates escalated later on and significantly increased the cost of the loan.

Adjustable rate mortgages (ARMs) have made up a reduced share of the home loan market ever since. Andrea Riquier, writing for MarketWatch, says about one in five home loans originated before 2008 had an adjustable rate. After the housing crisis and 2008 recession, ARMs made up less than 1 percent of home loans. They offered less of an advantage over fixed rate mortgages as the rates on this type of loan dropped to historic lows, and buyers could also rest assured that a fixed rate mortgage carried less of a risk.

However, ARMs are seeing some resurgence in popularity. According to Ellie Mae, a cloud-based platform provider for the mortgage finance industry, 9.2 percent of borrowers took out an ARM in December – an eight-year high and a significant increase from the 5.5 percent share for 2018 as a whole.

Adjustable rates can provide certain advantages to homebuyers, particularly those who are looking to save some money in the short term. But it's also very important to be aware of the risks of this type of loan.

Unlike a fixed rate mortgage, where the rate remains unchanged for the life of the loan, the rate of an ARM adjusts based on the market. Justin Pritchard, writing for the financial site The Balance, says rate changes are tied to market measures such as the Cost of Funds Index or London Interbank Offered Rate. Depending on shifts in the market, the rate may rise or fall.

This variability doesn't kick in until after an initial fixed rate period, after which the rate typically adjusts every year. For example, a 5/1 ARM mortgage is fixed at a certain rate for five years, then adjusts every year for the life of the loan.

Regulations established after the subprime mortgage crisis have helped reduce the risks of ARMs. John Allasio, writing for the retail mortgage lender Quicken Loans, says ARMs previously had shorter fixed rate periods, no caps on how high the interest rate could climb, and could be granted with zero money down. This meant the monthly payments could quickly skyrocket, making them unaffordable to borrowers and giving them little or no chance to build up equity in their property.

ARMs now limit how much the interest rate can change using periodic caps, which limit how much the rate can change during the adjustment period, and lifetime caps, which set a limit for how high the rate can go up at any time during the loan. ARMs usually have a 30-year term with different options for the initial fixed rate period, including five, seven, or 10 years.

It's important to understand the terms of an ARM before agreeing to one. The Consumer Financial Protection Bureau says you should know how frequently the rate will change, how high it might rise, and what limits there are to how much the interest rate should change. Calculate how your payments might change and determine whether you will still be able to afford the mortgage if the rate reaches the level stipulated in the periodic or lifetime cap.

One of the main advantages to ARMs is the ability to get a lower rate than what is available in a fixed rate mortgage. James McWhinney, writing for the financial site Investopedia, says this allows you to save a significant amount of money for the loan's initial period and potentially qualify for a larger loan.

If rates are steady, your payments won't change too much once the adjustable period begins. Lance Davis, writing for the financial site Bankrate, says your payments might even go down if rates fall during this period.

Of course, ARMs also carry the risk that rates will increase after the initial period, potentially resulting in higher costs than you would have realized with a fixed rate mortgage. A rapid increase in rates can more than double your loan's interest rate in a short period of time, and a rapid increase can also cause a sudden, unexpected increase in your payments if the periodic cap doesn't apply to the first change.

One particularly unpleasant possibility is negative amortization. Pritchard says this situation occurs when rates rise enough that your monthly payments won't pay off the interest you owe. When that happens, the extra interest is added to your loan principal, increasing the amount you owe.

Certain buyers are more likely to avoid these risks, making them better candidates for ARMs. Allasio says that if you don't plan on staying in the residence for a long time, you may be able to sell the home before the initial fixed rate period is up – allowing you to capitalize on the lower rate without having to deal with a changing rate later on.

You might also be better equipped to deal with the changing costs of an ARM if you expect a significant increase in your salary in the near future. McWhinney says this might be applicable to those entering a high-paying field such as medicine or law.

Other buyers might expect that they'll be well-equipped to pay off the loan in a short period of time. If you can pay off the remaining principal after the initial fixed rate period, you won't have to worry about any changes to the interest rate.

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