If you are looking to buy a home this year, the current interest rates may make the process feel overwhelming. In 2022, home financing costs nearly doubled1, leaving homebuyers struggling to find affordable mortgages in 2023. For some, the adjustable rate mortgage is a potential solution to this current economy, and can allow homebuyers to purchase a home with a lower interest rate and weather the current economic turbulence.
What Is an Adjustable Rate Mortgage?
An adjustable-rate mortgage, or ARM, is a mortgage with an interest rate that can change over the life of the mortgage. These loans have a fixed rate for an initial introductory period, then they can adjust based on a stated index, which is stated in the loan documents. These changes are tied to the Federal interest rate. This means the interest rate can increase or decrease to stay in line with interest rate trends.
Pros and Cons of ARMs
Like all mortgage products, ARMs have both benefits and drawbacks. As you choose the mortgage product that best fits your needs, you should consider these pros and cons.
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- Most of the time, an ARM has a lower interest rate for the initial period than a comparable fixed-rate loan. This can be a good way to address high interest rates.
- A lower interest rate means a lower monthly payment. This can make a home more affordable, especially for a first-time homebuyer.
- Finally, ARMs work well for people who know they are going to sell or refinance in a short period of time. They will save on interest, and then they can move to a different loan when they move or refinance the home.
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- The biggest drawback of an ARM is the risk that the interest rate will increase. At the end of the initial period, if rates have risen, then the rate and payment will increase. The terms of the ARM will limit how much this increase is, and often they have a percentage cap per move, but this can make the loan become more expensive.
- While many ARMs have more favorable loan terms when compared to a fixed-rate mortgage when the borrower first buys the home, such as a lower monthly payment, there is no guarantee that rates years later will be favorable for refinancing. Plus, without being able to predict your financial situation (i.e. job status and monthly income), there is no guarantee the borrower will qualify to refinance to a fixed-rate loan. Therefore, some borrowers may also find it difficult to refinance to a fixed-rate mortgage after the initial period term ends and enters the variable rate portion of the loan.
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The credit union offers three types of ARMs – a 5/6, 7/6, and 10/6. These numbers indicate how long the initial period is and how often the rate can adjust. The first number indicates the number of years you will have your initial loan locked in, so a 5/6 loan locks in that rate for five years, a 7/6 for seven years, and a 10/6 for ten years. The 6 indicates the rate can adjust once every six month after the initial period.
Is an ARM Right for Me?
Adjustable rate mortgages are a good fit for some borrowers. If you need to save money in the current economic climate with rising interest rates, and if you need to have a loan for a short period of time, then an ARM is an affordable choice.
The consideration is that you do not know what will happen to interest rates in the future. We are seeing all-time high rates right now, but we do not know if they will remain high or drop. There is the risk that your ARM will increase to the point that it is no longer affordable. You must decide if this is a chance you are willing to take.
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