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Should you take out an adjustable rate mortgage?

September 4, 2022 by Scott Sheldon

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Should you take an adjustable rate mortgage

With interest rates as high as they are consumers want adjustable-rate mortgages for payment relief. If you’re thinking about an adjustable-rate mortgage versus a fixed-rate mortgage here are some things, you need to be aware of…

The first few years of the mortgage loan are called a teaser rate.  A teaser rate is short-term and then adjust after a set period of time. Let’s say for example this teaser rate is 3.5% and then at the end of the 30-year term, the loan is paid off in full.  On a 5/1 ARM, the five represents the first five years that the interest rate is set for example the first 60 months. The one is the frequency at which point the interest rate can change one meaning every year. So, for the first five years, the interest rate is fixed, and then the remaining 25 years of the 30-year loan is then adjustable. This could adjust each year annually for the remaining 25 years of the duration of the loan.

The reason such programs are attractive these days is that they can be as much as 1% lower than the average prevailing 30-year fixed-rate mortgage. On the $500,000 loan that could result in about $400 a month lower in monthly payment. So, someone on a fixed income for example could benefit in the short term. Additionally, if this person needs money for just a short period of time, it could be beneficial. However, if you’re looking at a three-year or a five-year adjustable-rate mortgage, you have to qualify at 2% above the note rate. So, if the note rate on your 5/1 ARM for example is 4% that means you must qualify with a 6% interest rate. The same goes if the rate is 4.75% you must qualify at 6.75% on the fully amortizing rate.

The reason this is pertinent is that if you can’t afford the house and you can only afford the house on an ARM, then you cannot afford the mortgage. In such an example a 30-year fixed might be a better approach considering the debt ratio requirement can be higher. While at the same time 30-year mortgages are under 6% for primary homes, with good credit. Remember as 30-year mortgage rates rise adjustable-rate mortgage rates also rise in a lagging pattern.

As a result, your debt-to-income ratio might be adversely affected. If you’re going in thinking that you’re going to qualify and get an adjustable-rate mortgage only to find that you don’t qualify even though the monthly payment is several hundred a month less than the 30-year fixed. That might mean having to get a cosigner, put more money down, or pay off consumer debt. The other reality using our example on a 5/1 ARM -what happens if you can’t refinance after five years? What if you lose your job if interest rates rise, or if values ever drop? You could be left holding the bag. Granted such a scenario is very unlikely but still, the risk is there.

This is why the bank in exchange for sharing the risk they otherwise take on supplies a lower interest rate on a short-term loan like a 7-year or a 10-year loan. If you have 30% down or more, savings in the bank, have a good cash position, and you’re strongly backed financially; an ARM could be a good financial move. However, if your credit score is not good say under seven hundred and you don’t have the big down payment or the extra savings in the bank an adjustable-rate mortgage could be a risky proposition.

If you have a long-term plan for the house in mind, and you’re not sure how long you’re going to need the money a fixed-rate mortgage could be a better option. However, if you only need the money for a brief period and/or you might be selling the house within the first five years an ARM could be potentially a better solution. If you’re thinking about getting a mortgage or learning the intricacies of what mortgage loan is best suited to your financial situation start today by getting a  no-cost loan quote!

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Filed Under: Uncategorized Tagged With: Adjustable rate mortgage, ARM loan, buying a house, buying your first home, CA home buying, conventional loans, FHA mortgage, home buying, mortgage comparison shopping, sonoma county home buying

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