If You're Buying This Type of Home, Don't Get an Adjustable-Rate Mortgage

An adjustable-rate mortgage may not be the best call for certain home buyers.

If you're buying a home, you should aim to snag the most competitive interest rate you can on a mortgage -- one that makes your monthly payments more affordable, and helps you spend less on interest. And to that end, you may be tempted by an adjustable-rate mortgage, or ARM. While that may be smart in some situations, if you're buying your forever home, you're probably better off with a fixed-rate loan.

How does an adjustable-rate mortgage work?

When you take out a fixed-rate mortgage, you're guaranteed the same interest rate for the duration of your loan's repayment period. With an ARM, you lock in your initial interest rate for a limited period, then that rate can adjust. With a 5/1 ARM, for example, the rate you start out with remains in place for five years. But once those five years are up, your rate adjusts once per year.

Here's the interesting thing about ARMs -- your rate is not guaranteed to climb. It's possible for your rate to adjust downward, depending on market conditions. But when you sign up for an ARM, you have to assume that your rate will increase. And that's why an ARM may not be your best bet if you're buying a home to live in for a very long time.

A better choice for your forever home

If you're buying a starter home, an ARM could be a good bet. Say you get a 5/1 ARM and lock in a 2.9% interest rate for five years, whereas you'd pay 3.2% interest for a 30-year fixed loan. If you move out of your home within five years, you come out ahead financially, because you're selling (and thus paying off that mortgage) before your rate can adjust upward.

But if you're buying a forever home, a fixed mortgage is a safer bet. You lock in your interest rate for many years, and you don't have to worry about it climbing over time. And if you're able to swing the higher monthly payment for a 15-year loan, you might snag a lower interest rate than what even an ARM can offer.

Here's a look at mortgage rates as of this writing:

Data source: The Ascent's national mortgage interest rate tracking.

As you can see, you snag a better rate with a 15-year loan than with an ARM, and get a comparable deal with a 20-year mortgage.

What about refinancing an ARM?

You may be considering using an ARM for a forever home, and refinancing that loan if your rate climbs. But what if refinance rates become less competitive?

Say you can lock in a 30-year fixed loan at 3.2% now. What if, in five years, the average 30-year loan has a 4.7% interest rate? You might regret getting an ARM.

While an adjustable-rate mortgage makes sense when you plan to move fairly soon, it's risky when you make long-term plans. Consider the pros and cons carefully before signing up for a loan whose interest rate could change for the worse.