When it comes time to take out a mortgage on a property, there are many different types of loans available. From government-backed VA and FHA loans, to conventional fixed-rate 15-, 20-, or 30-year loans, there are lots of options to consider. One avenue you may not have considered — and may have even been warned against — however, is an adjustable rate mortgage, or ARM loan.
Adjustable-rate mortgages got something of a bad rap during the housing market crash of 2007 and brought many banks' lending practices under the microscope of scrutiny. During that time, lenders would often use ARMs, which carry lower initial interest rates, in order to get borrowers' payments where they need to be in order to qualify for loans. The catch? When the interest rate would adjust, borrowers would be stuck with a higher interest rate and, in many cases, a higher payment they simply couldn't afford.
What exactly is an ARM?
An adjustable-rate mortgage (ARM) is not a long-term, fixed-rate mortgage. Instead, it offers borrowers a lower initial interest rate for a shorter fixed period of time — usually three, five, or seven years. While the principal and interest payment on the loan is still calculated over 30 years, the interest rate changes based on several factors once that three-, five-, or seven-year time period is up. Those factors include:
- Interest rate indexes – ARMs are tied to an index of interest rates such as the London Interbank Offered Rate, also known as Libor. Libor is one of the benchmark rate indexes used by leading banks to dictate what they'll charge each other for short-term loans.
- Margins – The loan margin is established when the loan is initially approved and remains fixed for its entirety. The margin is a fixed percentage that is added to a loan index rate to obtain the fully indexed rate for an ARM. For example, if your index rate is three percent and your margin is three percent, your fully indexed interest rate would be 6 percent. Margins can sometimes be negotiated with the mortgage lender.
- Interest caps – ARMs typically have a cap that defines a maximum interest rate and a periodic cap limiting the amount the interest rate can change within a single adjustment period.
Why more people are choosing ARMs
As the general public has become more informed about ARM loans and their potential benefits and pitfalls, more borrowers are opting for these types of mortgages when it makes sense. Let's take a look at four of the reasons more borrowers these days are opting for ARMs.
1. Lower interest rates = lower monthly payments
When interest rates are already low, ARMs are less popular among borrowers. But because interest rates on ARM loans are always lower than on conventional fixed-rate loans — generally by about .5 percent — they're particularly appealing at times when conventional interest rates are high. During these times borrowers are often willing to risk a higher future rate in exchange for lower payments now.
2. Short-term loans
Some homebuyers choose ARMs because they know they will not keep the loan long enough for the introductory rate to expire. Therefore, they know they can avoid the interest-rate adjustment. For this reason, ARMs can be a sound option for those buying investment properties or fixer-uppers that they intend to hold onto for only a few years. The most popular ARM loans carry fixed-rate terms of five or seven years, which gives most investors plenty of time to get in and out of the property, and make the lowest possible payments in the meantime.
One word of caution here: It's important to make sure that you are aware of any prepayment penalties associated with the loan. For example, some loans carry a penalty of 2 or 3 percent if they are paid off early. Refinancing a loan or selling the property both result in the original loan being paid off and that penalty can be assessed in these cases if the prepayment period has not yet expired. This can end up costing an unwitting homeowner a significant chunk of change. Therefore, be sure to ask your lender about prepayment penalty details if you plan to refinance your way to a lower payment after the initial low-interest period expires, or to sell the property quickly.
3. Lower fraud risk
While ARMs are less appealing to some borrowers, they're also less appealing to would-be identity thefts and criminals, according to recent data. First American, which provides mortgage and title services, said earlier this year that there is now less fraud risk associated with adjustable-rate mortgage applications than with conventional loans.
"ARMs historically have had more defect, fraud and misrepresentation risk than the traditional 30-year, fixed rate mortgage," said Mark Fleming, chief economist at First American. "Interestingly, that has changed recently. ARMs, based on our defect, fraud and misrepresentation index, are modestly less risky."
4. Lower credit scores
Borrowers with credit scores that dip below 680 are less likely to qualify for conventional loans and therefore will end up paying higher interest rates. Higher interest means higher monthly payments. Borrowers and their lenders often circumvent this problem with an ARM loan. The lower associated interest rate can make a big difference in a borrower's ability to qualify for a mortgage loan and to make the monthly loan payment.
Should you consider an ARM?
If you are interested in an adjustable-rate mortgage for these or other reasons, it's important to weigh all of the pros and cons with your mortgage lender to ultimately determine if an ARM is right for you. If you believe your credit score may prevent you from qualifying for a conventional loan with a low interest rate, it's a good idea to do a free check of your credit score before applying for a mortgage loan. Doing so can save you money in the long run.