When you’re ready to purchase a home, you’ll find there are many mortgage options available. But no matter the loan program you use, the interest you pay will be structured in one of two ways: fixed or adjustable. 

While the majority of mortgage applications for both refinances and purchases are for fixed-rate loans, there are some advantages to the adjustable-rate option that are often overlooked.

Understanding the options 
A fixed-rate mortgage charges a set interest rate that remains unchanged throughout the life of the loan, typically 15 or 30 years. 

With an adjustable-rate mortgage (ARM), the interest rate varies throughout the life of the loan. The initial interest rate is usually lower than on a fixed-rate mortgage, and the rate is locked in for a certain period of time, typically 3, 5, or 7 years. Once the fixed-rate period ends, the interest rate adjusts depending on the index it uses. This means your monthly payments can increase or decrease. Most ARMs include an interest rate cap that sets a limit on how high the rate can go. 

ARMs are categorized by the length of time the interest rate remains fixed and how often the rate is subject to adjustment. For example, in a 5/1 ARM, the 5 stands for the initial 5-year, fixed-rate period while the 1 shows that the interest rate is then subject to adjustment once a year. 

The benefits and drawbacks
Unfortunately, ARMs have received a bad rap since the 2008 housing crash. In 2005, approximately 40% of new loans were ARMs. However, many of those loans had risky features, including shorter fixed-rate periods, negative amortization, higher lifetime caps, and prepayment penalties. Many ARMs were approved with little to no money down, and buyers often got into these loans without fully understanding the features and risks. 

Today’s ARMs are structured quite differently than they were in the past, and Wayne Lacy, branch manager with Cherry Creek Mortgage, says they can be advantageous for some borrowers. 

“It depends on your goals and how long you plan to be in the home,” he said. “For instance, if you have a 3-year employment contract and know you’ll be relocating after, an ARM can be a great option. Or, if you are buying a home as an investment with plans to fix it up and sell it in the next 3 to 5 years, an ARM may work for you.” 

If you see your family staying put for more than 10 years, the typical advice is to go with a fixed-rate mortgage. But Lacy says even for buyers looking at something more long-term, and ARM may still be a good option.  

“Generally speaking, the average life of a mortgage is just over 5 years,” he said. “At that point, a large number of homeowners either sell or refinance. So, based on that statistic, the 5-year ARM may actually be one of the best products on the market.” 

As always, there are pros and cons to each option. With a fixed-rate loan you get simplicity and predictability. But, interest rates are typically higher, which means less buying power and higher monthly payments. 

By using an adjustable-rate mortgage, you’ll have lower, predictable payments during the fixed-rate phase. If interest rates fall after the initial period, there’s a possibility that your monthly payment could drop. On the other hand, if interest rates are rising, your payments could increase and some borrowers might have trouble making larger payments. 

While qualifying criteria can vary from lender to lender, buyers who choose an ARM may need a higher credit score and a larger down payment than those who use a fixed-rate option. And, even if you plan to sell or refinance before the adjustable period begins, things don’t always go as planned. If you’re unable to sell or refinance, you will be on the hook for your new rate. 

The Consumer Financial Protection Bureau says before choosing an ARM, it’s important to find out: 

● How high your interest rate and monthly payments can go with each adjustment
● How frequently your interest rate will adjust
● How soon your payment could go up
● If there is a cap on how high your interest rate could go
● If there is a limit on how low your interest rate could go
● If you will still be able to afford the loan if the rate and payment go up to the maximums allowed under the loan contract

“There’s never a one-size-fits-all answer when it comes to mortgages,” said Lacy. “ARMs won’t be right for everyone, but I encourage borrowers to be more open-minded about them. A reputable lender will discuss your options, make sure you understand the benefits and risks, and help select the right loan product and terms that work best for your individual situation.” 

If you’re thinking of buying a home and would like more information about available loan programs, visit the Greater Lansing Association of REALTORS® website at www.lansing-realestate.com for a list of trusted area lenders.