When are Adjustable Rate Mortgages a Good Idea?
Interest rates have been so low for so long, adjustable rate mortgages have almost become an endangered species. An entire generation of new homeowners has probably never even considered an alternative to a fixed rate mortgage.
Should rates continue to rise steadily as many expect, more and more lenders will likely dust off their ARM products to give their less risk-averse customers a choice. Under the right conditions, ARMs save tens of thousands of dollars in interest payments.
Adjustable rate mortgages take many forms, but all feature an interest rate that periodically adjusts based on an index which reflects the cost to the lender of borrowing on the credit market. The most popular format begins with very low “teaser” rate for five or seven years, which then changes—or “resets”—to fluctuate with the prime rate or another index linked to inflation.
ARMs are especially suitable for borrowers who expect to move before any rate increases can wipe out the savings in the early years. They’re also useful for sophisticated borrowers wrestling with uneven income, borrowers who expect their income to rise, or borrowers who are willing to bet they can invest their mortgage savings for a greater return somewhere else besides equity in their homes.
ARM borrowers take the risk that they refinance should rate rise significantly after they reset and they don’t always win. During the crash in housing values after the housing bubble burst in 2007, thousands of ARM borrowers defaulted on their homes when values fell so far that they did not have enough equity to refinance. They could not meet the great increases in their monthly payments and were left with mortgages that cost more than their homes were worth.
Memories of those times continue to stigmatize ARMs even though most of the ARM products today are safer than the “interest only” and option ARMs of 12 years ago. Borrowers of option ARMs, “pick-a-pay” loans, could choose a very small monthly “teaser rate” payment but found themselves in deep trouble when the combination of small payments and falling values drove them into negative equity and they could not escape a two or three-fold increase in their monthly payments after their loans reset.