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3 Reasons an Adjustable-Rate Mortgage Is a Bad Idea

This article has been updated on 12/10/2014.

At first glance, an adjustable-rate mortgage, or ARM, is a rather eye-opening thing. It boasts the lowest interest rates, and the payment made on the loan is often 15% or so less than on a traditional mortgage. Yet while these products may make sense for a variety of people in different life stages, there are a few reasons that would cause people to scratch this type of mortgage off their list of possibilities when buying a home.

ARMs come in a variety of options, but typically the payment is locked in at a lower interest rate for the first three, five, or seven years, after which it changes each year based on the going market rates. For example, at today's values, a person could have a 5/1 ARM with a rate of 2.69% for years one through five, but then beginning in year six and through year 30 -- 25 years in total -- the rate would change annually.

In the same situation, a person could secure a traditional 30-year mortgage at a rate of 3.8%, and the payment would stay the same over the life of the loan.

Although they can be compelling, ARMs faced a lot of scrutiny coming out of the financial crisis thanks to various attempts to manipulate them. For example, the the NINJA loan -- "no income, no job, and no assets" -- was an ARM product.

In an effort to better understand who would and would not be best suited for an ARM loan, I spoke with Jim Linnane, retail division sales manager with Wells Fargo Home Mortgage. Although the ultimate decision is up to the individual and not the banker as to what product is the right one, Linnane stressed the need for each person to make an informed choice when considering any financial decision and noted three reasons an ARM may not make a whole lot of sense.

1. You're buying a home, not a house
Those are my words and not Linnane's, but he stressed that ARMs make a ton of sense for people who know they probably won't be in their home longer than five to seven years. But if a home is purchased with the intention of living in it for the duration of the mortgage and beyond, then a traditional mortgage, especially at today's radically low rates, is the preferred choice.

For example, a single 27-year-old buying a two-bedroom home knowing he or she will probably be married, have children, and move out of that house within the next five years would have a compelling reason to consider an ARM. However, a 35-year-old married couple with three children buying the home they plan on living in until they retire may not want the potential headache or risk that comes with an ARM.

Although there are certainly a lot of people would who want to consider an ARM depending on their circumstance, Linnane added that "with fixed rates as low as they are, there is no doubt that a fixed rate for many people is going to be the smartest choice."

2. Your income is stable
A stable income is a great thing. Yet one of the compelling reasons to get an ARM, Linnane said, is that if your income is likely to grow by a significant amount in the future -- consider a doctor in residency, or an executive at a company. Therefore, if you're in a stable job in which your income will probably stay relatively the same, save for some modest raises, an ARM may not make much sense at all. That's because, at the end of five years, your rate is likely to climb, and it could climb dramatically.

Consider the example of 2.69% ARM versus a 3.8% traditional mortgage.

In each scenario if you put 20% down on a $200,000 home would result in payments of about $650 and $745, respectively, over the first five years. With the ARM, you'd save roughly $6,000 in payments alone, and you'd have an additional $2,800 of equity built up in the home after the first five years.

Yet at the end of year five, if rates had risen 5% -- the maximum amount allowed in many deals -- your 5/1 ARM at an interest rate of 7.69% would result with in a mortgage payment of $1,060. That's an increase of more than $400, or 60%. In year six, you'd end up paying almost $4,000 more with an ARM than with the traditional mortgage.

Now, if your income rose by 60% over that time period, this kind of mortgage increase might be a shock, but on a relative basis it would all net out. But for many of us, a 60% rise in housing costs would be a big deal. And let's face it: A 75% rise in income is pretty unlikely.

3. You have savings, but you still run a little lean
One of the benefits of the Great Recession was that it forced Americans to reevaluate their financial positions -- and many people began saving more of their income.

But although our savings rate has risen, many of us still don't have quite the savings we need to feel comfortable with the prospect of a rising mortgage payment.

Going back to the same example from earlier, if rates rose just 2.5% over the first five years, the mortgage payment of the 5/1 ARM would jump to almost $850 in year six, an increase of $200.

While this isn't nearly as dire of an example as the 5% increase, it would still mean an additional $2,800 in mortgage payments in year six alone. Not having a comfortable savings buffer to help eliminate the burden caused by a potential increase in rates is another reason that would eliminate an ARM from your consideration.

The bottom line
If you're thinking about buying a home, there's probably a mortgage that will specifically suit your needs. And with the right amount of digging you can figure out exactly what that is, whether it be a 15- or 30-year fixed rate, or a 5/1 or 7/1 ARM, or anything in between. Just make sure to do your research to figure out what the best option is for you and your finances.

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Read/Post Comments (5) | Recommend This Article (8)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 03, 2013, at 10:22 AM, Strkr1 wrote:

    I appears that the author of the article has a very limited grasp of how mortgages actually work. Unfortunately, while some of the advice he gives is at least marginally correct / helpful. The "numbers" that he gives for ARM's and what they can go up to are wrong. After 5 years, assuming the ARM goes up to the maximum, the principal and interest payment will be 1,083, NOT 1,160. The mistake he makes is that he takes the new interest rate and applies it to the original principal over 30 years. The ACTUAL calculation should be the REMAINING principal (141,900) over the next 25 yrs... a $77 per month difference. Same thing with the second example (2.5% increase) the payment is not 900/m, it's 860.

    He also doesn't even bother to calculate the amount of time that it would take to lose or even break-even on the savings from the past 5 years of lower payments.

    I expected better.

  • Report this Comment On November 03, 2013, at 11:31 AM, normgarry wrote:

    I work in mortgages.

    ARM loans are what killed the market: specifically those given to people with questionable careers and incomes. The 2/28 (fixed for two years and adjustable for 28 years) was nothing more than a scam to sell a person a mortgage that they absolutely couldn't afford. The lie told to them was that "over time their horrible credit would improve and they'd be able to refinance into a fixed mortgage later down the road".

    The best home mortgages are fixed. ARM are loans for people who have enough money to be able to gamble with a second investment property. Even if you screw up and lose the 2nd property, you still have your main property which is ultimately your greatest investment.

  • Report this Comment On November 03, 2013, at 11:52 AM, gslam wrote:

    I am always surprised at how many first time buyers read articles like this and assume a 5/1 is too risky for them and overpay for a 30 fixed. Coworkers buy their first house rarely consider how long they are going to stay in the new house. They only consider 30 year fixed because it is "safer".

    By using 5/1s we have paid off more principal and benefited from upswings on a larger base because we are able to buy more house. We have moved or refied before the reaching the breakeven point.

    We also paid attention to the market and downsized before the market adjustment.

  • Report this Comment On November 03, 2013, at 4:24 PM, Seanickson wrote:

    I got a 5/5 arm at 2.75 because the difference on the payments were so extreme that it allowed me to give a big boost to my investing. It can increase by up to 2% every 5 years depending on the 5 year note to a maximum of a 5% increase. It is indeed a better product for those that dont intend to be in their home for greater than 5-10 years.

  • Report this Comment On November 04, 2013, at 5:31 PM, edteked wrote:

    This article makes the assumption that after the fixed portion of the ARM has expired, that the rate will rise.

    Well, it will also go down! 20 years ago I had a 5/1 ARM at 5.5%. Fixed 30 year was 8.5%. My rate went down every year for 4 years till the rate was only 1.5%. Then it stayed at that for a few years, then it started going back up. We had the loan for 15 years and never went above the starting rate of 5.5%. When we sold the house, we purchased into a 10/1 interest only..but we were smart, we pay over $1,000/month extra to pay down the principle. in 8 years, we have payed down a 10/1 interest only loan by over $30k! And all this at a fixed interest rate for the first 10 years! So, yeah, these loans may not be for everybody, but if you do it right, then it's good!

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