First, let’s go over some of the differences between an ARM and a traditional fixed-rate mortgage. Fixed-rate mortgages offer the same interest rate over the life of the loan. With an ARM (adjustable-rate mortgage), the interest rate adjusts with market interest rates. The interest rate for an ARM is tied to a market index, such as the LIBOR or a regional COFI (cost of funds index).
Advantages of an ARM
Many ARMs offer an introductory period with a fixed rate, after which the interest rate changes at given intervals (For example, a 5/1 ARM offers a fixed rate for 5 years, after which the rate resets annually). The interest rate during the introductory period of an ARM is usually significantly lower than interest rates for conventional mortgages. This can save the borrower a lot of money in the first few years of the mortgage.
In addition, ARM holders will benefit from periods of low market interest rates. If the index rate falls, ARM holders can take advantage of these low interest rates without having to refinance. However, if you took out a fixed 30-year loan with an interest rate of 3.6%, the interest rate would stay at 3.6% every year, no matter what happened to the market.
Disadvantages of an ARM
The downside to an ARM loan is that when the index rises, the interest rate rise as well. ARM holders are still vulnerable to rate increases and often find that as the loan progresses the interest rate rises significantly, making monthly payments much harder to afford. Some ARMs offer rate caps to protect against interest rates rising to unreasonable levels, but not all – check the fine print!
The Bottom Line
An ARM is a smart move for short-term homebuyers who can take advantage of the low interest rates for several years before selling the property. Some buyers will take out an ARM loan to take advantage of low interest rates and then refinance when the initial period is up, but there is no guaranteeing what market rates will look like at that time. Taking out an ARM for the long-term is not necessarily a bad idea, but make sure you are prepared for possible spikes in interest rates
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