Buzz
While housing prices are starting to drop, rising interest rates have made monthly mortgage payments less affordable than ever. In these financially uncertain times, you might be considering an adjustable-rate mortgage, which is becoming more popular again. If the term sounds familiar, it's because ARMs played a major role in the 2008 housing crash—and they are still a risky option to avoid today.
What exactly is an adjustable-rate mortgage?
An adjustable-rate mortgage (ARM) initially offers a lower interest rate than a conventional fixed-rate mortgage, typically for the first 5-7 years of the loan. However, after this initial period, the interest rate can fluctuate—either increasing or decreasing—depending on market conditions. While ARMs provide the advantage of lower monthly payments at the start, they are risky because payments can change over time, sometimes significantly. In contrast, a fixed-rate mortgage guarantees the same payment throughout the life of the loan.
It's also important to note that your ARM payment can still rise even if interest rates drop. That's because adjustable-rate mortgages have a cap on how much the interest rate can increase in a single year. However, it may also have the option to carry over any excess rate hike to a future adjustment. So while other borrowers might see their rates fall, yours could go up instead.
Is an ARM ever a smart choice?
An adjustable-rate mortgage is a bet that either interest rates will drop in the future, allowing you to refinance at a lower monthly payment, or that your income will rise, enabling you to handle higher payments when the rate on the loan increases. However, even if interest rates decrease, refinancing may not be possible due to a low credit score or a decline in the home's value, which could drop below the amount still owed on the mortgage. (Housing prices can fall to the point where you owe more than the house is worth—this is what happened in 2008 when prices dropped by around 20%.)
It could make sense for those who know they’ll sell the home before the fixed-rate period ends: this would allow them to take advantage of the lower rate temporarily and exit before the rate potentially rises. However, it's crucial to remember that unforeseen circumstances might prevent you from selling as planned, making it still a risky move.
