When Does an Adjustable Rate Mortgage Make Sense?

During the financial crisis in 2007 and 2008, millions of mortgage borrowers defaulted on their loans sending Wall Street and the mortgage industry into a nosedive. With billions of dollars in losses on the horizon, bankers and news anchors were touting the problems of adjustable rate mortgages and balloon payments. But are adjustable rate mortgages all bad? Not at all! Let’s take a look at when adjustable rate mortgages make sense.

You plan to live in the home less than the fixed rate period

If you plan to live in a home less than five years, you may be better off renting. But in an environment where you think the value of the home will go up by more than the transaction costs to buy and sell, it can make sense to buy a home for a shorter period of time.

Because the interest rate is locked in for five years, seven years, or some other period of time, you know your rate will not change within that time frame. If you get a seven year ARM and plan to live in the home less than seven years, you are most likely safe with the adjustable rate loan.

However, if your plans change and you decide to stay longer, don’t be surprised when your monthly payment goes up. PenFed Credit Union offers a 15/15 ARM that locks in the rate for 15 years. Because this is such a long period, it can be a great deal if you plan to live in a home for a while but may move or refinance within 15 years.

You think interest rates are going down in the future

Interest rates sat at rock bottom rates for a long while here in the United States. While it was possible to get mortgage rates below 4% for a few years, it seems that time has come and gone. There are still some bargains to be had, but for the most part it seems rates are on the way back up.

The Federal Reserve Board sets the Fed Funds Rate, an interbank lending rate for overnight loans between banks. Because banks are for-profit businesses, they borrow from customers (savings accounts, CDs) at a rate lower than the Fed Funds Rate and lend (mortgages, auto loans, business loans) at a higher rate. The difference between the two is the bank’s profit.

Mortgage rates have been low for a while, but as the Fed has been raising rates lately, the market rates for mortgages are going up as well. If you got a letter from your bank letting you know your credit card interest rate has gone up, expect new mortgage rates to go up by at least that amount as well.

Adjustable rate mortgage: rolling the dice?

In some ways, an adjustable rate mortgage is a big gamble. While we can see that rates are slowly climbing today, we don’t know what will happen two, three, five, or more years from now. The economy could fall into a crisis and the Fed may respond by lowering rates. The economy might boom leading to ever higher interest rates.

In the 1980s, interest rates for mortgages were much higher than they are today. In January 1982, a 30-year-fixed mortgage had a 17.48% interest rate, that is more than four times the rates we’ve seen over the last 5+ years. If you have an ARM and rates skyrocket, it wouldn’t be unheard of to see your interest rate rise toward 20%.

In many ways, getting a long-term mortgage with an ARM loan is like rolling the dice in Las Vegas. Rates could stay the same or go down, which could save you a bundle. But if rates go up, it can cost you big. Keep in mind that rates can only go down a few percent before they reach zero, but they can go up infinitely. In many ways banks have the same odds as a casino, the house always wins.

And when it doesn’t, the government will bail it out anyway. But that’s a story for another day.

Think long-term when choosing a mortgage loan

If you have a daily Starbucks habit and spend $5 days at the coffee shop 365 days a year, you will spend $1,825 per year on coffee. That’s a lot, and somewhere many savvy budgeters look at to save. But a 1% change in interest rate on a $250,000 loan is $2,500. And unlike coffee that you can stop and start whenever you want, you are locked into your loan and can’t choose whether or not you want to pay.

Buying a home is one of the biggest purchases you will ever make, so don’t take it lightly. Focus on the long-term ramifications of the loan you choose. With a fixed rate loan, you won’t have any surprises as long as you hold the loan. But with an ARM, you are throwing caution to the wind to some extent and will pay whatever the market decides. That very well may mean higher payments in the future.

If you get to know your finances and think long-term, you have little to worry about. When it comes to mortgages, the conservative approach is likely the best strategy. You don’t want any expensive surprises coming down the road, and an ARM may lead to just that. But in some situations, an ARM does make sense.

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