This article has been updated on 12/10/2014.
Many bemoan the lack of choice when it comes to certain things in life, but there's no shortage of options when it comes to mortgages. There's the fixed rate, adjustable rate, 30-year, 15-year, jumbo, ARM, and some smattering of all of those mixed together.
But the adjustable-rate mortgage, or ARM, may be the best option -- depending on your circumstances.
The ARM is a curious one, as it often carries the lowest rate, yet it represented only 4.4% and 6.5% of all mortgages originated in 2009 and 2010 (the most recent years for which the data is available). The way a tradition 5/1 ARM works is that it has a fixed rate for five years, but then the interest rate and payment will change (probably going up) from years six to 30, depending on the market rates. In a traditional 30-year mortgage, the rate and monthly payments are locked in for the life of the loan.
At times, ARMs have drawn the ire of both consumers and industry groups. A simple Google search reveals a May 2011 article from popular financial commentator Dave Ramsey outlining "Why an Adjustable Rate Mortgage Is Bad," a CBS News article from a few weeks later titled "Why Adjustable Rate Mortgages Are Still a Really Bad Idea," and even a Huffington Post blog entry from February of 2013 proclaiming "The Adjustable Rate Mortgage: Just Say No."
Yet as with most things, there are two sides to the story. I spoke with Jim Linnane, retail division sales manager with Wells Fargo Home Mortgage, who said an ARM is "like any other topic in financial services: Whether or not it's a good thing or a bad thing, it depends."
Linnane believes that the mortgage decision should be up to the borrower and that the correct choice depends on individual circumstances. But he said the most important thing is making an informed choice when it comes to the products. He highlighted three characteristics of borrowers that would probably make ARMs more sensible than traditional mortgages.
1. Duration in the property
Linnane said that if a borrower intended to stay in a house for a shorter period of time, then an ARM should "absolutely be considered."
For example, if a homeowner planned on being in a house for between three and five years, for a $200,000 home with 20% down, a 30-year fixed rate mortgage at today's rates of 3.80% would cost approximately $745 per month, and a 5/1 ARM at 2.875% would be $650 a month, for a savings of $6,000 over the first five years. Yet not only will the monthly payment be cheaper, but at the end of the five years the ARM would also allow the borrower to pay more than $18,500 in principal, compared with $15,750 in the traditional mortgage.
Before any potential rate increase could occur, the borrower would have paid less and built more equity in the home, resulting in more than $8,500 in savings and additional equity. If the buyer's intention was to sell the house and move out within that five-year window, this could be a very sensible option.
Another common strategy in that situation is that if the borrower can comfortably make the same payment required by the traditional mortgage but still have an ARM with the lower rate, then it would make an immense amount of sense to contribute that higher amount.
In our example, if the borrower with the 5/1 ARM contributed an additional $100 of their monthly savings straight to the principal balance, after that same five-year period the borrower would pay the same amount as the traditional mortgage.
But instead of having $15,750 of equity in the home -- not including the down payment -- it would stand at more than $25,000.
For people who know they probably won't remain in their homes beyond a five-year period as the result of personal, work, or family situations, an ARM could make a lot of sense.
2. Potential for income growth
ARMs may also make a lot of sense if there's a strong likelihood that personal income will rise, since any potential risk of an increased payment from a rate increase on an ARM would be mitigated.
If circumstances dictate that you stay in the home longer than you previously believed, the increase in income over the five years would serve as a "little bit of a hedge in the adjustment to a higher interest rate," Linnane said.
3. Personal savings
Finally, Linnane highlighted the need for personal savings and the need for financial discipline if you're truly considering an ARM. Although your payment is fixed for five years, if rates increase in year six and beyond, then not being prepared for a potential "payment shock" could be a significant problem.
ARM regulations require that the maximum rate increase over the initial rate stands at 5%. But if in year six rates jump from 2.69% to 7.69%, the mortgage payment would jump over $400 to stand at $1,060.
"If there was any doubt that you wouldn't be out of the property in five years, then you would have to mitigate your risk through either increased income or with reserves that you have saved," Linnane said.
As a result, Linnane noted a final caution was that it's vitally important to understand the parameters of the ARM and know the nuanced aspects of the agreement. Doing the calculation for the maximum potential rate increase and understanding the costs associated with it is crucial, he warned, as "too often the benefits of the low interest rates gets a lot of attention, but where rates could go doesn't get as much attention."
The bottom line
Adjustable-rate mortgages can be a great tool depending on your circumstance, but it's vitally important to understand both the benefits and risks before making your final, educated decision.
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