If you are looking to buy a home soon or to refinance your current mortgage, you know that interest rates are very low. In recent weeks, the average rate on a 30-year fixed-rate mortgage is below 3%. In fact, rates have been setting record lows for a while. And yet, you may have seen adjustable-rate mortgages advertised with interest rates below those stunning rates, maybe around 2.25%. While that lower rate can seem very enticing, here’s why ARM loans are not the best option in today’s economic climate.
How ARMs Work
Adjustable-rate mortgages have ultra-low interest rates for an initial period of one, five, seven, or even ten years. After that time, the rate is allowed to adjust periodically based on certain market indexes. That means your rate could go up if the markets are doing well or fall if they are sluggish. There are maximum limits set on how much your rate is permitted to rise in one adjustment period and how much it can increase total over the course of your loan, but your rate can still jump significantly enough to raise your monthly payments dramatically. That is the risk of ARM loans, if you are unprepared to make much higher payments, you might have to default on your mortgage, potentially leading to foreclosure.
When ARMs Makes Sense
Of course, there are times when ARM loans can be helpful. If interest rates are high in general, an adjustable-rate mortgage might help you save a bunch of money in the first few years when your rate is fixed below the going market level.
ARMs also make sense when you do not plan to stay in a home for very long. If your initial ARM rate will last five years, but you plan to move within three to four years, you would never have to face the looming rate increases. For example, say you took out a $300,000 ARM loan at 2.25% that adjusts annually after the first five years. Your monthly payment would be $1,146.74. Compared to a 30-year fixed-rate mortgage at 2.75% where your payment is $1,224.72, you could save $78 a month, and over five years that would amount to $4,680 in savings. Sounds worthwhile, right?
When Fixed-Rate Loans Beat ARMs
The problem with that scenario is that because interest rates are at rock-bottom right now, many lenders are not offering wide spreads between fixed-rate and adjustable-rate loans. The difference between the two types currently is only between a quarter and three-eighths of a percent, making the potential savings less worth the risks. Some lenders are not even advertising ARM loans at all, only 15- and 30-year fixed mortgages.
And while rates may continue to fall slightly if the effects of COVID-19 drag out, there is a very real chance that they will increase over the next five years. If you are planning to stay in your home for the long haul or even just longer than five years, you could forfeit the lasting savings of today’s low rates.
Unless you are absolutely positive you’ll be moving within the next few years, or if you are confident you can refinance into a better rate in the near future, a fixed-rate mortgage will serve you better today than an adjustable-rate mortgage.
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