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The Pros and Cons of ARM Loans

Mortgage loans come in many forms, including adjustable-rate mortgages, which are often called “ARM loans.”

These loans have a unique structure that allows the interest to go up or down alongside current rates. Instead of a locked-in rate for the life of your loan, you have a rate that can change as the years go by.

Like all mortgage programs, having a full knowledge of ARM loans is essential when you want to make an informed, confident decision.

Understanding ARM Loans

As the name implies, an adjustable-rate mortgage is a loan with an interest rate that can go up or down through the years. Initially, your ARM loan will have a fixed-rate period, which usually lasts from three to ten years. During that period, the rate will not change at all. Once the period is complete, however, your rate will be adjusted depending on interest-rate indexes. Essentially, the rate of your loan will be tied to the interest rates that are set by various indexes.

ARM loans are designated with two numbers; the first designates the fixed-rate period, while the second number designated how often the rate will be adjusted. A 5/1 ARM loan, which is one of the most common forms, has a fixed-rate period of five years; after that, the interest is adjusted to current indexes every year. (If it were 5/2, the rate would be adjusted every two years.) You’ll also see 3/1 ARM loans, 10/1 ARM loans, and more.

The exact interest rate applied to the loan will depend on the loan details, but it is usually the base interest rate (from a specific index), plus a margin, which is usually about 1%. Therefore, if the index rate is 3.75%, your interest would likely be about 4.75%. (Again, this can change depending on the contracts; margins can be higher or lower.)

Pros of ARM Loans

Low Initial Costs

The biggest attraction for ARM loans is the low initial costs. During the fixed-rate phase, you will have lower costs for your loan because of a reduced interest rate. If you have a 5/1 ARM loan, for example, you’d have five years of locked-in interest, giving you predictable payments for that time. Also, because you are taking a risk with future interest rates, the bank is sometimes willing to reward you with a lower initial payment compared to fixed-rate loans.

Greater Flexibility

If your lifestyle is expected to change in the next few years, due to a move or a new job for example, you may benefit from an ARM loan. If you’ll be selling the home within a shorter timeframe, you can take advantage of the lower payments and sell before moving into the adjustable-rate period. (Just be careful of early-payment fees, which we will address below.)

With lower initial costs, ARM loans may help you afford the house you want.

Rate Increases and Payments are Often Capped

While the thought of increasing payments can be scary, most ARM loans have caps on both the interest and the total payment amount. For example, most programs will have a limit on the amount an interest rate can increase from year to year, as well as the amount it can increase in total. Likewise, the contract will likely state that the total payment can only go up to a specific amount, giving you a greater sense of stability and predictability.

Potential for Smaller Payments

The emphasis here is certainly on the word “potential,” but with ARM loans, you do have the chance to see reduced payments from your home loan because if interest rates drop, so does the rate on your loan. Generally speaking, when the economy is strong, the Federal Reserve will raise base interest rates, but if the economy slows, interest rates can be lowered in an effort to encourage activity. If this happens, you could see a lower payment.

Cons of ARM Loans

Potential for Larger Payments

When interest rates rise, your payments will rise as well. In the near future, interest rates are expected to rise, but over the life of a thirty-year loan, it becomes much harder to predict what interest rates will do. After the phase of locked-in payments, you could find yourself with higher monthly costs, which is a big reason for people who avoid ARM loans.

Prepayment Penalties

One of the ways to utilize ARM loans is to pay them off or refinance before the adjustments come, but many ARM loans are structured with adjustable rates, leaving you with extra costs if you want to pay it off or close the account. If you are considering an ARM loan, be sure to ask about all potential fees, including prepayment penalties.

Complexities Bring Confusion

Compared to a fixed-rate mortgage, ARM loans can be very complex, with multiple rules, fees, and structures that affect your monthly payments and total costs. These complexities can create added risk for buyers who don’t fully understand the details, and can lead to financial trouble in the future if unexpected expenses arise.

When Should You Choose an ARM Loan?

So when should you choose an ARM loan? While every situation is different, there are a few situations that may lead people to choose this option. First of all, if you plan on selling your home or refinancing within the next five to ten years, it may be worthwhile to choose an ARM, as you can take advantage of the fixed-rate, lower-cost period without being hit by increases later. (Assuming the prepayment penalties are manageable.)

If you have reason to believe that your income will increase in the future, you could be a potential candidate for ARM loans. You’ll get the initial lower payment, and when the payment increases, you’ll have the income to handle the higher costs.

Finally, if there is a good reason to believe that interest rates will decline in the future and you’re comfortable with the risk, then perhaps it’s time to look at ARM loans.

Get Reliable Advice for ARM Loans

ARM loans are not for everyone, but with reliable guidance and sound advice, you may find that this option could be right for you.

Contact San Diego Purchase Loans today and we’ll help you understand the details of this type of mortgage.