Why a Larger Down Payment Could Be Even More Important With an ARM
A small down payment could leave you regretting your adjustable-rate mortgage.
When you get a mortgage, you'll have to decide if you want a fixed-rate loan or an adjustable-rate loan (ARM). With an ARM, the rate can adjust over time as opposed to a fixed rate which remains the same for the life of the loan.
Typically, an ARM has a lower starting rate than fixed-rate loans, which can make it seem attractive since it's more affordable. But it's only locked in for a short time. It could be locked in for just five years (a 5/1 ARM) or seven (a 7/1 ARM). After that time, it adjusts with a financial index, and the rate, monthly payment, and total loan costs could go up.
If you're thinking about getting an ARM, you may want to make sure you're making a good-sized down payment. While a 20% down payment is always beneficial in order to have a good choice of lenders and avoid getting stuck paying for private mortgage insurance, making a generous down payment can be even more important with an ARM.
A low down payment makes an ARM riskier
Making a good-size down payment -- ideally 20% and definitely no less than 10% -- is important when taking out an ARM because if you put down too little money, this could pose problems later on.
When you have an adjustable-rate loan, there's a very good chance that your rate could start adjusting upward once the initial period with the fixed interest rate expires.
Many people who get ARMs don't actually want to take a gamble on whether their loan interest costs will rise every single year -- potentially making their payments unaffordable. Instead, the goal is often to sell the house before the initial rate starts adjusting or to refinance into another ARM or even into a fixed-rate loan before the rate begins adjusting.
If you sell the house prior to the rate adjustments, then you benefit from the lower starting interest rate the ARM offers without having to risk paying high rates later. And if you refinance before it starts adjusting, then you benefit from that low rate for a few years and can then either get another low interest ARM to extend that time for a few years or get a fixed-rate loan and benefit from the certainty that loan type offers.
The problem, however, is that you cannot refinance or sell your home if you owe more than the property is worth. And if you don't make a generous down payment, there's a very real chance that could happen if property values fall even a little bit. If your home declines in value and you can't sell it for enough to pay off your loan or you can't qualify to refinance your mortgage, you could be stuck in your ARM once rates begin adjusting.
You don't want to be trapped with a loan that's adjusting and potentially making payments more expensive. In that case, you may be unable to do anything about it because you're underwater on your loan. A large down payment ensures that won't happen, so it reduces the downside risk of an ARM considerably.
If you're thinking about getting an ARM and don't have much to put down, you may want to reconsider whether that decision is the right one for the long term.
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