If you have ever sought a mortgage, the term ARM has probably cropped up at some point during the course of conversation. ARM stands for Adjustable — Rate— Mortgage. There are many of variations of ARMs, such as 3/1, 5/1, 7/1, and even 10/1 ARMs (indicating that the rate is fixed for 3, 5, 7, or 10 years and can then adjust every after that). The idea behind them is all similar; you pay less during the initial years (due to a lower-than-market rate), but then assume the risk of a variable interest rate after the fixed period is over.
Rates have been historically low for quite some time, but they are starting to climb (the Fed just increased interest rates last month above record lows for the first time in 7 years) and it is safe to assume that they will continue to increase as the economy improves, so the short logic behind an ARM is:
Lower Rate Now, Higher Rate Later
There is much more to ARMs than this simple statement, but the variations of ARMs on the market are mainly just different expressions of this axiom (lower rate now, higher rate later)
So, when should you get an ARM?
There are many arguments for ARMs (and many against), but I think ARMs should be considered in either of the 2 scenarios:
· You are QUITE certain that you will be selling before or shortly after the fixed period of your ARM is over.
· You are QUITE certain that interest rates will be declining after the fixed period of your ARM is over.
Notice the emphasis on certainty. Years ago, I bought a home with a 5/1 ARM and was certain that I would be selling it before the 5 years was up. Life happened, and while we did move, we ended up renting out the home and carried the mortgage for years beyond the 5-year fixed period (fortunately, the Great Recession hit during the same time, so our rate didn’t increase). Many of the clients refinance from variable rates to fixed rates had the same plan: “we’re only going to be here for a short time.”
You should also consider the rates/pricing of Fixed rate mortgages and compare it to that of ARMs. Often (as in today’s market), 30-yr fixed rates are only slightly higher than ARMs (if you are being offered a rate substantially lower, they are likely charging an enormous amount of closing costs and may be adding them to your loan). If a fixed rate gives you payment that is only slightly higher than that of an ARM, it may be wise to go with a fixed rate.
This may be helpful to know: We make the same amount of money on an ARM as we do with a Fixed-rate mortgage (there is no financial incentive for me to push a Fixed Rate over an ARM). In the 10+ years that I have been originating mortgages, I have advised an ARM over a Fixed rate mortgage only once (and have yet to have a client pick an ARM over a Fixed rate mortgage). If someone is strongly recommending an ARM, I would be skeptical. However, if we are ever in a market where interest rates are high or there is a significant different between a Fixed rate mortgage and the starting fixed term of an ARM, they may make more sense.
In short, ARMs have their place, though they rarely make sense for most borrowers. If you’re not careful, you’ll spend and ARM and a LEG. I had to do that…
