Adjustable-rate mortgages have had some bad press over the past few years, taking heat for contributing to the massive housing bust that brought the U.S. economy to its knees. Consequently, fixed-rate mortgages, known for their predictability, have become the go-to loan product for many borrowers.
But that stability comes at a cost—higher interest rates—and may end up being needlessly expensive.
Consider this: The typical mortgage is paid off or refinanced in seven to 10 years. If you have a seven-year window, why pay for 30 years worth of interest-rate stability?
Here are some things to think about when considering whether an adjustable-rate mortgage is right for you:
Aren't All ARMs Risky?
While some ARMs deserve their reputation for being risky and dangerous, the most exotic ARMs don't exist anymore.
What's left these days are hybrid ARMs—mortgage products that start out with a fixed interest rate for a period of three, five, seven, or 10 years, then change to an adjustable rate. As the mortgage landscape has morphed over the past few years, these products have become increasingly competitively priced, making them a viable and money-saving option for some buyers.
While interest rates for 30-year fixed-rate mortgages hover around 4 percent on average, the average 7/1 Hybrid ARM—an adjustable rate mortgage with a 7-year fixed-rate period—has an interest rate of about 3.125 percent, according to HSH.com. With a $200,000 loan, your monthly payment will be about $100 less with the ARM than with the 30-year fixed. Over a seven-year period, that rate difference will save you almost $12,000 in interest costs and pay down about $3,600 more of your principal.
Bottom line: You'll be forking over less to the big banks and owning more of your home faster.
Know the Risks
Currently at or near historic lows, interest rates have virtually no place to go but up. Because ARMs have a finite fixed-rate period—meaning that borrowers only have the guarantee of the fixed rate for a certain period of time—the risk of rising interest rates makes it a top concern.
The only way to avoid the risk of skyrocketing mortgage payments is to make sure your timeline dovetails well with the fixed-rate period of the loan. If you will pay off or refinance your loan by the time the fixed period ends, there is no risk at all.
But what if your crystal ball isn't all that clear?
The key to ARMs is to fully understand the risks involved. In a worst-case scenario, the interest rate for the 7/1 ARM can rise as much as five or six percentage points after seven years. However, for the worst case to occur, the short-term interest rates which govern an ARM's rate change (called the "index") would need to jump from a rate of about 1 percent (today) to about 6 percent.
While not impossible, that large of a jump in the index is unlikely. Still, even a milder rise in the index could push up your loan's interest rate to 6.125 percent, which would increase your monthly payment by just under $300 per month. Whether a worst-case increase or a smaller one, either circumstance would be unwelcome for most homeowners.
Plan For An Increase
The way to avoid a payment increase completely is to refinance or close the loan by selling before you get to this point. However, there is a way to dampen the effect of a rise in payment by socking away some of what you save in interest payments by going with an ARM as opposed to a fixed-rate mortgage.
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You save about $100 per month if you chose the 7/1 Hybrid ARM over the 30-year fixed. If you bank half of that—$600 per year—you'll accumulate more than $4,200 over the seven-year period. If your timeline hasn't worked out as precisely as you planned and you're still in your home after the fixed-rate period ends, you'll have a sizable financial cushion you can draw upon, keeping your monthly budget from being wrecked by a sharp mortgage payment increase. This can buy you valuable time to move or refinance as needed.
Refinancing into an ARM can also work well for borrowers nearing retirement. If you know you will be selling your home and retiring in seven years or less, you could stuff an additional $12,000 or more into your IRA or 401(k) by getting an adjustable-rate mortgage.
A 25-year expert observer of the mortgage and consumer debt markets, Keith Gumbinger has been cited in thousands of articles covering a wide range of consumer finance and economic topics in outlets ranging from the Wall Street Journal to the Bottom Line newsletters. He has been a featured guest on national broadcasts for CNN, CNBC, ABC, CBS, and NBC television networks and has been heard on NPR and other national and local radio programs. Keith is the primary researcher and writer for HSH.com's MarketTrends newsletter and has authored or co-authored a number of consumer guides on mortgages, home equity, refinancing, and more.