Adjustable rate mortgages, or ARMS, were blamed for playing a part in the financial crisis. But, these once-shunned loans are becoming an increasingly attractive option.
Banks typically charge significantly lower initial interest rates for ARMs than for fixed-rate loans. However, after the initial period ends, an ARM interest rate will change periodically, usually in line with an index. Your payments might go up or down. An ARM loan typically has a “cap,” the highest interest rate that the loan can adjust to.
Currently the most popular ARM has a fixed rate for five years, but other versions fix the rate for as long as 15 years. Generally, the shorter the fixed-rate period, the lower the initial interest rate, while the longer the fixed-rate period, the more time before the loan’s interest rate adjusts and a higher rate could potentially click in.
Some banks are even doing interest-only ARM loans again. For example, PNC Bank recently introduced several interest-only ARMs that allow borrowers to postpone paying any principal for as long as 10 years. The interest rate also can remain fixed for up to 10 years.
Does an ARM work for you? It depends on many factors – if you expect your income to rise, how long you plan to live in your home, if you think your home will appreciate. But, the wise homebuyer does look at the downside; if the rate would rise to the maximum cap, can you still afford your mortgage?
The savings can be considerable. Borrowers who sign up for a $400,000 10-year ARM with an initial interest rate of 3.64 percent would save $2,000 per year compared with a 30-year fixed rate mortgage of 4.14 percent.
One financial planner we know suggests that homeowners taking out ARMs use the monthly savings to reduce principal.
If you are curious about mortgage payments, use the Newport Cove’s mortgage calculator to see how your monthly payment adjusts depending upon your interest rate. (Incidentally, ARM loans are usually loans with a 30-year term.)