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Should I Consider An Arm Instead Of A Fixed Rate Mortgage?

Sammamish Mortgage
March 29, 2016
Last updated:
October 21, 2021
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In This Article

Summary: When you apply for a mortgage, you have plenty of options, including whether to opt for a fixed-rate or adjustable-rate mortgage. But when does it make more sense to go with an adjustable-rate mortgage (ARM)? This article will explain.

Mortgage rates for fixed-rate loans are still lower than they have been in decades. Why in the world would anyone want to consider any sort of adjustable rate mortgage?

Even with today’s low fixed rates, opting for an ARM could save you significantly.

How Adjustable Rate Mortgages Work

First, you should be aware of how ARMs work. The most popular loans are called “hybrid ARMs” or “Intermediate Term ARMs.” These loans have rates that are fixed for an extended period of time—typically 3, 5, 7 or even 10 years—before they begin to adjust. At that time, the interest rate will change annually based on the performance of an index, like the One Year Treasury.

The lender adds a number, called the “margin,” to the index to arrive at the new rate for that year. The index changes every month, but the margin is set at the time the loan funds; it never changes. If the index is 1.21 when it’s time to adjust the loan and the margin is 2.25, the new rate will be 3.46%.

View Current Mortgage Rates Oct, 24, Sun, 2021

There are limitations, called “caps,” on how much the rate can adjust initially, annually and over its lifetime. For ARMs with a fixed period of five years, for example, the initial and annual caps are 2%, but the “life cap,” the highest the rate could ever increase, is 5%.

This means that if you selected a start rate of 3.625% and an initial fixed term of 5 years, the loan could adjust to no higher than 5.625% at the first change, and no more than 8.625% at any time.

Lower Monthly Payments

ARMs offer lower rates at the beginning than fixed rate loans. An ARM with a fixed period of 5 years will carry a rate of around .375% lower than a 30 year fixed rate. For a $300,000 mortgage, the monthly payment would start about $64 less than the fixed rate loan. Those savings could mount up over time: that same loan would accrue nearly $4,000 in savings in five years, compared with the fixed rate option.

But there is still the matter of the uncertainty of a loan that will change in the future. What if interest rates are higher in five years? That ARM that seemed such a bargain at 3.625% could rise to 5.625% after five years. The rate could rise all the way to 8.625% in just seven years; would it still be a good deal?

Should You Choose an ARM?

There is no simple answer to whether anyone should select an ARM over a fixed—although few people ever regret getting a fixed rate mortgage. But there are a few cases where an ARM could be worth considering.

  • If you are certain that you’ll be selling your home before the first adjustment, you could save money with an ARM, since you would pay off the loan before its first adjustment.
  • If you need a lower rate to qualify for the home you want to buy, you may be willing to take a chance on a rate that may increase in five or seven years.
  • If you believe rates will still be low when the loan begins to adjust, you can plan for it. Homeowners today with ARMs that started at 5% six or seven years ago are enjoying rates today below 3.5%. If you are comfortable dealing with that unknown, you may feel that today’s lower rate is worth taking a chance on the future.

It is true that the 30-year fixed rate mortgage is the most popular loan in the marketplace today—and for good reason. Rates are still low, and the knowledge that your rate won’t change for as long as you have the loan is very comforting. But if you identify with any of the circumstances mentioned here, you may decide that one of today’s ARM loans is an appropriate choice for you.

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