Best Strategy for an ARM (Adjustable Rate Mortgage)
The key to earning the most savings from an Adjustable Rate Mortgage is to turn this mortgage into a shorter-term loan. That’s because ARMs come with an adjustable period during which their interest rates can rise or fall depending on economic conditions.
If your ARM’s interest rate rises, which it almost certainly will once it enters its adjustable phase, your monthly payment will increase, too. But if you either sell your home or refinance your ARM to a fixed-rate mortgage before this adjustable phase hits, you’ll boost your odds of nabbing the most savings from an ARM.
How ARMs work
To take advantage of this strategy, it’s important to understand how ARMs work.
When you first take out an ARM, the loan is in its fixed-interest-rate period. During this period, which typically lasts from five to seven years, your loan’s interest rate won’t change. The benefit here is that ARMs usually come with initial interest rates that are lower than what you’d get with a standard fixed-rate mortgage, giving you a lower initial monthly payment.
Once the fixed-interest-rate period ends, your ARM enters its adjustable interest-rate phase. During this period, your ARM’s interest rate will change, often once a year, depending on whatever economic index it is tied to. How long the adjustable period lasts depends on your type of ARM. If you took out a 30-year ARM with a fixed period of five years, your loan’s adjustable period will last 25 years.
For example, a 5/1 ARM comes with a five-year fixed period, indicated by the number 5 in the 5/1 ARM. After those five years, your loan’s interest rate can adjust once a year, indicated by the number 1 in the 5/1 ARM.
A 7/2 ARM comes with a seven-year fixed period, after which your interest rate can rise or fall two times each year, or every six months.
During the adjustable period, your loan’s interest rate will often increase. If you decide to hold your ARM on a long-term basis, make sure that your household budget can handle a higher monthly mortgage payment. You must also be comfortable with the uncertainty that comes with knowing that your monthly payment might change each year or every six months, depending upon how often your loan’s interest rate is set to change.
Avoiding the adjustable period
Many borrowers who take out ARMs do so knowing that they won’t hold on to the loans for their full terms. Many plan to get out of their ARMs before the adjustable period begins.
There are two ways to exit an ARM before its adjustable period begins.
- Sell your home. You can sell your home before the adjustable period begins, paying off your existing mortgage from the proceeds. Some people only plan on being in their homes for five to seven years. They might take out an ARM to take advantage of the lower initial interest rate and then sell their homes before the adjustable phase kicks in.
- Refinance. You can refinance your ARM to a fixed-rate mortgage before the ARM begins its adjustable phase. Again, this allows borrowers to take advantage of lower introductory interest rates without having to go through the uncertainty that comes with an ARM’s adjustable period.
Cautions with ARMs
Keep in mind that there is no certainty that you’ll be able to refinance or sell your home according to your schedule. If your home’s value falls, you might not build enough equity to refinance. And if the housing market changes, you might struggle to find a buyer for your home or at the price you need to sell it.
Be sure, then, that you can afford a higher mortgage payment if you can’t get out of your ARM before the adjustable period begins.
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