by Christy Bieber | July 19, 2021
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Don't get an adjustable-rate loan without reading this.
An adjustable-rate mortgage (ARM) is an alternative to a fixed-rate loan. As their names suggest, the rules for interest rates work very differently with each loan.
With a fixed-rate mortgage, your interest rate stays the same for the whole time you're borrowing. Payments never change, and you know total costs from the start. But with an adjustable-rate mortgage, your rate is guaranteed for a short time initially, and then it can adjust or change. These adjustments usually happen around once per year, as it tracks the movement of a financial index.
Adjustable-rate mortgages have some features that make them attractive to borrowers -- but there are downsides to consider as well as upsides. Before you decide an ARM is right for you, consider these three big benefits and one huge downside.
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When you compare adjustable-rate mortgages with fixed-rate loans, there's one immediate benefit that will become apparent. Chances are very good that the interest rate you'll be offered for an ARM is below the interest rate that you'd get if you took out a 30-year mortgage with a fixed rate.
Lower interest rates, of course, make a loan seem more attractive. After all, interest is the cost of borrowing. If you can keep this cost down, you won't have to send as much of your hard-earned money to the lender.
And since you're borrowing a lot of money when you get a mortgage loan, even a small reduction in the interest rate could have a huge impact on your monthly payment and costs to borrow.
When ARMs have a lower interest rate than their fixed-rate counterparts, this makes monthly payments more affordable. As a result, it could be easier to qualify for an ARM than for a fixed-rate option -- especially if you have a lot of debt already or if you are taking out a large mortgage loan.
Lenders consider your debt-to-income (DTI) when deciding on loan approval. That's your monthly payments relative to monthly income. The higher your mortgage loan, the more debt you have relative to earnings, and the harder it is to get approved to borrow. In fact, many lenders have a maximum cut-off point of a 38% DTI, so if your ratio is higher, you'll have a harder time finding someone to give you a loan.
The low starting payment on an ARM also enables you to take out a larger loan than you might be eligible for if you opted for a more expensive fixed-rate loan. This is also explained by your debt-to-income ratio.
If you borrow more to buy a home, your monthly mortgage payment goes up and so does your DTI. But if you can get a lower rate by choosing an ARM over a fixed-rate loan, you should be able to raise your principal balance because you'll be paying less interest.
By now, you're probably wondering why everyone doesn't get an ARM since they are cheaper and easier to qualify for.
The problem is, the ARM is adjustable. So while it may start out cheaper, it's not necessarily going to stay that way. In fact, if your interest rate adjusts up, your payments could become much higher.
You could end up with substantially higher total interest costs over time than if you'd taken out the fixed-rate loan. And if you opted for an ARM because you were struggling to qualify for the loan you wanted with the fixed-rate loan, you could be in real trouble if the ARM ends up being even more expensive.
You need to seriously think about the dangers of rates rising before you opt for an ARM, because it's not always possible to refinance or sell your house before the rate starts adjusting.
Unless you're confident you could pay your mortgage even if your rate goes up -- and you're OK with taking a big chance on your loan costs being much higher than planned -- you should likely opt for the safer fixed-rate loan option.
Chances are, interest rates won't stay put at multi-decade lows for much longer. That's why taking action today is crucial, whether you're wanting to refinance and cut your mortgage payment or you're ready to pull the trigger on a new home purchase.
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