Pros and Cons of Adjustable Rate Mortgages (ARMs)

Adjustable rate mortgages have several advantages that fixed rates don’t offer. However, the drawbacks may outweigh the benefits for many Americans.

Continue reading to find out the pros and cons of adjustable rate mortgages (ARMs) and whether or not it makes sense to pursue this type of interest rate for your next mortgage.

Pros and Cons of Adjustable Rate Mortgages

Adjustable rate mortgages are certainly not right for everyone. In fact, the Mortgage Bankers Association reported that ARMs made up only 12 percent of mortgage applications in 2022. However, in certain situations, ARMs may make more sense for some homebuyers. 

Pros of ARMs

Initial Lower Interest Rates

The primary advantage of adjustable rate mortgages is that they often start with a lower interest rate compared to fixed-rate mortgages. This can be especially beneficial for borrowers who are on a tight budget or those who want to qualify for a more expensive home. 

The lower initial payments can make homeownership more accessible and affordable, particularly in a housing market with rising prices and high fixed rates.

Additionally, if you plan to stay in the home for only a few years or expect an increase in income in the future, the lower initial payments of an ARM can allow you to get into the property and build equity without committing to higher monthly payments associated with fixed-rate mortgages.

» MORE: Why Did My Mortgage Go Up if I Have a Fixed Rate?

Short-Term Savings

One of the significant advantages of ARMs is their potential for short-term savings on interest expenses. During the initial fixed-rate period, which can range from a few months to several years, the borrower enjoys a stable interest rate that won't change. 

This can be particularly beneficial if you are planning to sell the property or refinance before the first rate adjustment.

For example, if you plan to move or refinance within five years, opting for a 5/1 ARM (where the rate is fixed for five years and then adjusts annually) can allow you to take advantage of the lower introductory rate without facing the uncertainty of future interest rate changes. 

This way, you can save money on interest during the fixed period and then move on to a new property or refinance into a different loan without being exposed to the risk of higher rates.

Flexibility

Adjustable rate mortgages offer borrowers greater flexibility in their home financing options. The variety of adjustment periods available (e.g., 1 year, 3 years, 5 years) means borrowers can choose the option that aligns with their financial plans and expectations.

For borrowers who know they will move or refinance in the short term, ARMs can be an attractive option. They can enjoy the lower initial rates and avoid the potential downsides of rate increases since they won't be holding the loan when the rate adjusts. 

Cons of Adjustable Rate Mortgages

Rate Uncertainty

One of the most significant drawbacks of adjustable rate mortgages is the uncertainty surrounding future interest rates. After the initial fixed-rate period ends, the interest rate will adjust based on prevailing market rates, which can be influenced by economic factors, inflation, and monetary policies.

If interest rates rise, as they tend to do during periods of economic growth or inflationary pressures, borrowers with ARMs will face higher monthly payments.

Additionally, rate uncertainty can make it difficult to plan for the long term. Homeowners may find it challenging to budget accurately when their mortgage payments are subject to change, and this uncertainty could impact financial stability.

Budgeting Challenges

Because adjustable rate mortgages have fluctuating interest rates, borrowers may encounter challenges in long-term budgeting.

Unlike fixed-rate mortgages, where the monthly payments remain stable throughout the loan term, the payments on ARMs can vary after the initial fixed-rate period. As a result, homeowners might need to adjust their budgets and financial plans each time the rate adjusts.

Rate Caps and Limits

While ARMs come with rate caps, which are limits on how much the interest rate can increase during an adjustment period and over the life of the loan, these caps may not fully protect borrowers from significant rate hikes in certain situations.

For example, some ARMs have initial adjustment rate caps that limit the increase in the interest rate at the first adjustment. However, after the first adjustment, there might be higher adjustment caps or no caps at all, potentially leading to large rate increases in subsequent adjustment periods. 

In some cases, these rate increases can be substantial, resulting in a significant spike in monthly payments for borrowers.

Negative Equity Risk

Another significant risk associated with ARMs is the potential for negative equity, also known as being "underwater" on your mortgage. Negative equity occurs when the outstanding loan balance exceeds the current market value of the home.

In a declining housing market, the value of the property may decrease, while the outstanding mortgage balance remains the same. 

If homeowners need to sell their property during such a market downturn, they might not be able to recoup the full outstanding loan amount through the sale. This situation can lead to financial difficulties, making it challenging for homeowners to sell or refinance their properties without bringing additional funds to cover the shortfall.

The Bottom Line

Potential homeowners should consider the pros and cons of adjustable rate mortgages before making any decisions. 

It’s always a good idea to talk with your mortgage loan officer by explaining your financial situation. They will most likely be able to provide you with guidance on which option makes the most sense to you and your family.

» MORE: 8 Tips When Saving for a Down Payment