Over the last few years it has been an extreme seller’s market characterized by low inventory and rising home prices. Home sellers have been in the drivers seat.
Most homes listed for sale have experienced bidding wars with sales prices ending up far over the asking price. It has been the ultimate nirvana for home sellers. Not so much for home buyers who have seen their dream home become more and more expensive.
Home buyers have been afforded the luxury of ultra-low interest rates, so some of the pain of high home prices has been absorbed by such attractive mortgage rates.
In real estate all good things eventually come to an end. Markets eventually shift one way or another.
Unfortunately, mortgage rates have risen now to the point where some buyers have been locked out of the market.
In order to continue to search for their dream home, they have been forced to consider an adjustable mortgage rate. Adjustable rate mortgages (ARM) tend to offer lower interest rates than fixed-rate mortgages, but they are also more risky for borrowers.
At a moments notice, an adjustable rate mortgage can shoot upwards and become a less affordable financing alternative.
Let’s look at the downsides of an adjustable rate mortgage so you know what you’re getting into.
What Are The Cons of An Adjustable Rate Mortgage?
What is an Adjustable Rate Mortgage?
An adjustable rate mortgage (ARM) is a type of mortgage that allows the borrower to lock in a rate for a certain period of time.
The most common time period for an adjustable rate mortgage is 3, 5, 7, or ten years. In other words, when the terms of the mortgage interest rate can change. Variable rate mortgages are still typically amortized over 15-30 years.
Usually the shorter the adjustment period, the more attractive interest rate you will receive.
The downside to this type of mortgage is that if interest rates rise during the term of the loan, the monthly payment may increase significantly.
Additionally, if market conditions change and the interest rate on ARMs rises above the rate offered at origination, borrowers may struggle to keep up with monthly mortgage payments.
Adjustable Rate Loans Have a Fixed-Rate Time Period
Adjustable rate mortgage programs will have a stated period of time where the interest rate will be fixed. When the fixed time frame ends, the adjustment period starts.
Once the variable rate period starts it will change based on a benchmark rate stated in the loan.
For example, if you have a three year adjustable rate mortgage, the interest rate will remain fixed for those three years. At the end of three years the interest rate can and will change.
There Are Annual and Lifetime Caps on The Mortgage Rate Increasing
There are many factors that contribute to the interest rate you will pay on your mortgage. These include your credit score, the amount of down payment you make, and whether or not you are a first-time home buyer.
The amount your interest rate changes for an adjustable rate mortgage will largely depend on the broader financial and economic conditions.
As previously mentioned, the rate used for an adjustable rate loan will be tied to a bench marked reference point.
It is commonly tied to the U.S Treasury rate. When the bench mark rates rises, so does the interest rate with your variable rate loan.
There are “caps”, however as to how much your interest rate can increase in a year. Typically, the rate is capped at 2 percent.
So if you started with a 4 percent loan, it could not go any higher in one year than 6 percent.
There is also a lifetime cap on interest rates as well. Most of the time the cap will be set at 6 percent, although there are some programs where it could be lower.
So using the same 4 percent example, the highest the interest rate could rise over the life of the loan is 10 percent.
Keep in mind that market conditions will dictate whether interest rates go up or down.
Who Are Adjustable Rate Mortgages Good For?
Two are the most common types of borrowers where adjustable mortgage rates make sense are those who are transient and those who need a lower rate to qualify to purchase a home.
When you are constantly being relocated for work and know you won’t stay in one place for a long time, an adjustable rate loan makes sense.
If you know you’ll be in a property for an extended period of time a fixed-rate mortgage would offer more financial stability.
Some borrowers need a lower rate to be able to become a first-time buyer or even purchase a second home. They may even look at some of the lower income housing choices.
One of the significant advantages of adjustable rate mortgages is they typically have lower initial rates.
Downsides of an Adjustable Rate Mortgage
There are some potential downside risks with an ARM. Your mortgage interest rate could increase, causing your monthly mortgage payments to go up.
If you’ve been living on a fixed income it could impact your lifestyle from a financial standpoint.
When the interest rate on your ARM changes during your loan term, you could end up owing more money than you originally planned.
If you have a low down payment and the real estate market faces a downturn, you could end up owing more money than your house is worth.
When the market value of your home falls below your original purchase price, you may end up losing money because your loan balance will be greater than what you paid.
This could happen even if the interest rate on your ARM remains unchanged – if house prices fall sharply enough, you may owe more than what is still owed on your original mortgage balance.
When you need financial stability in your life going with an adjustable rate is not the way to do it. One the other hand, if it is the only way to get into a home, it may make sense.
In such cases it will make sense to monitor interest rates and if they drop, you can refinance into a fixed-rate loan.