The Pros And Cons Of Adjustable Rate Mortgage Loans
Published May 21, 2012
According to the National Association of Realtors, last year, about one out of three home buyers paid for a home in cash. If that sounds high, that’s because it is. It was a record year for cash payers largely because sinking home prices allowed many people to buy real estate by dipping into their savings.
But regardless of what’s happening in the real estate market, the vast majority of people who want to buy a house haven’t saved nearly enough money to buy it. They have to borrow money and they need a mortgage.
About 70 percent of the people who need to borrow money to buy a house opt for a fixed-rate mortgage while all of the others choose a type of adjustable rate mortgage. There are many different types but adjustable rate mortgages all have one thing in common: They come with interest rates that go up or down, depending on current market rates. If rates are historically low, as they have been for a few years now, it’s more likely than not that the interest rate on an adjustable rate mortgage will rise, and vice versa.
In this article, we’ll look at the advantages and disadvantages of adjustable rate mortgages, starting with the advantages.
The Pros Of Adjustable Rate Mortgage Loans
- Adjustable rate mortgages always offer an initial interest rate that is lower than you would get from a fixed-rate mortgage. For example, if you can get a fixed-rate mortgage with a 5-percent interest rate, you probably can get an adjustable rate mortgage that starts at 4 percent or less than that. (To learn more about the differences between fixed rate and adjustable rate mortgages, see Comparing Fixed-Rate And Adjustable-Rate Mortgage Loans.)
- Because you at least initially will pay less interest with an adjustable rate mortgage, obtaining one might help you do one of two things: save more money or afford a larger mortgage to buy a larger or nicer house.
- If you have an adjustable rate mortgage, your interest rate can drop if market rates fall. This, of course, is more likely to happen if you obtain an adjustable rate mortgage when interest rates are historically high. If rates are high, they are more likely to drop, and so will the interest rate on your mortgage.
- Adjustable rate mortgages can save you thousands of dollars if you plan to be in the house for only a few years. Under that scenario, you can save money on interest payments in the short term and may have moved and sold the house before the interest rate approached what you would have paid had you obtained a fixed-rate mortgage. That explains why adjustable rate mortgages are common for those in the military who are assigned to an area for three years or for people whose companies move them to another city for a few years.
- Hybrid adjustable rate mortgages can be great for home buyers. These types of mortgages can start out as a fixed-rate mortgage and morph into an adjustable rate mortgage after a specific number of years. A 3/1 mortgage, for example, has a fixed interest rate for three years and then an adjustable rate mortgage. Home buyers also can obtain 5/1, 7/1 and 10/1 mortgages.
- Adjustable rate mortgages come with annual and lifetime caps which prevent interest rates from rising above a certain level during a 12-month period or the lifetime of the loan.
The Cons Of Adjustable Rate Mortgage Loans
- Interest rates rise when market rates increase. This fact, more than anything else, scares home buyers, especially when interest rates are historically low as they have been in recent years. The general feeling is that if they’re very low, they can only go up.
- The first interest rate increase can be quite large and the annual cap rules often don’t apply to the first increase. First-year increases can jump 2 percent or more which can translate into significantly larger monthly mortgage payments.
- If you plan to keep your house for several years, interest rates for adjustable rate mortgages over time will typically exceed interest rates for a fixed-rate mortgage.
- If interest rates eventually surpass those for a fixed-rate mortgage, it may make sense to refinance to obtain a fixed-rate loan and that will cost thousands of dollars. In a worse-case scenario, you may not be able to afford to refinance and you may no longer be able to afford to pay your mortgage. If you lose your house, you will damage your credit, making it very difficult to qualify for another mortgage. (For more information about how to avoid foreclosure on your home, see 3 Ways To Avoid Home Foreclosure.)
- The interest rate for an adjustable rate mortgage may increase once a year or it may increase as frequently as quarterly or even monthly.
- Assuming your mortgage fluctuates regularly because your interest rate goes up and down, it becomes difficult to maintain financial stability and difficult to budget.
As you can see, there are plenty of pros and cons to adjustable rate mortgages and it is pretty obvious that they are right for some home buyers but not all. Learn more about adjustable rate mortgages and then talk with an experienced and trusted mortgage banker to figure out if they are right for you.
Last Updated: May 21, 2012