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The Best Candidate For an Adjustable Rate Mortgage

Author: Andrew Taylor

Adjustable-rate mortgages (ARMs) offer borrowers a lower interest rate than a conventional fixed mortgage, but that rate doesn't last forever, which means this mortgage product isn't going to work for everyone. After all, adjustable-rate mortgages have been out of favour with many financial planners ever since the housing meltdown that ushered in an era of foreclosures and short sales. Back then, borrowers faced sticker shock when their ARMs adjusted, and their payments increased greatly. Many had to walk away from their homes because they couldn't afford the new payment. Another knock against ARMs is low-interest rates. Interest rates have been hovering at record lows ever since the recession of 2008, leaving many wondering if they should go with an adjustable-rate mortgage at all. While all of this may send most home buyers heading for the hills, ARMs do make sense for a certain group of borrowers. Whether or not you are a good candidate for an adjustable rate mortgage depends on a lot of factors from the time you plan to stay in the home to your future earnings potential. (Read more, here: The Fuel The Fed The Subprime Meltdown.)

ARMs Are Attractive For Short-term Homeowners

One of the disadvantages of an adjustable-rate mortgage is that the interest rate you pay isn't fixed for the entire loan like a conventional mortgage. When borrowers take out a fixed-rate loan, they know they will pay the same interest rate over the life of the loan. With an ARM, the interest rate changes over a period. Let's say you took out a one-year ARM with a lower interest rate than a fixed mortgage. That would mean you get to enjoy that lower interest rate for a year and then the loan would reset each year to match the prevailing interest rate. That's fine if interest rates are low as they have been for the last few years, but if rates go up, you are likely going to end up paying more than you would with a conventional fixed-rate loan. (Read more, read: Mortgages: Fixed-Rate Versus Adjustable-Rate.)

ARMs come in different terms from one year to as long as seven years, which is why an ARM might not make sense for someone who plans to keep their home for more than seven years. However, if you know you are going to move in a short period, or you don't plan to hold on to the house for decades to come, then an adjustable-rate mortgage is going to make a lot of sense. Take this example to gauge your potential savings: let's say you take out a seven-year ARM with an interest rate of 3.5%. A 30-year fixed rate mortgage, in comparison, is going to give you an interest rate of 4.25%. If you plan on moving and selling the home before the five-year ARM resets you are going to save a lot of money on interest, but if you ultimately decide to stay in the house longer, and rates are higher when your loan adjusts then the mortgage is going to cost more. Predicting the future isn't easy to do but if you are purchasing a home with an eye toward upgrading to a bigger home once you start a family, or you think you'll be relocating for work, then an ARM may be right for you. (Related reading: 6 Tips For Selling Your Home Fast.)

You Expect An Increase In Your Earnings Potential

A big reason people got in trouble with adjustable-rate mortgages is that when the interest rate reset, the loan payment increased a lot each month, and they could no longer afford to make their monthly payments. For people who have a stable income but don't expect their income to increase shortly, a fixed-rate mortgage makes more sense. However, if you expect to see an increase in your income, going with an ARM could save you from paying a lot of interest over the long-haul. Let's say you are looking for your first home and you just graduated from medical school, law school or earned an MBA. The chances are high that you are going to earn more in the coming years and will be able to afford the increased payments once your loan adjusts. In that case, an ARM will work for you. (Read more, here: When Is An MBA Worth It?)

You Plan On Paying Off The Loan Before Your ARM Resets

Taking out an adjustable-rate mortgage is very attractive to mortgage borrowers who have or will have the cash to pay off the loan before the new interest rate kicks in. While that doesn't include the vast majority of Americans, there are situations where it may be possible to pull it off.

Take a borrower who is buying one house and selling another one at the same time as one example. That person may be forced to purchase the new home while the old one is in contract and, as a result will take out a one or two-year ARM while the borrower awaits payment from the sale of their home. Once the borrower has the money, they can turn around pay off the ARM with the proceeds from the home sale.

Another scenario in which an ARM would make sense is if you can afford to accelerate the payments each month by enough to pay it off before it resets. Employing this strategy can be risky because life happens and while you may be able to afford to make accelerated payments now if you get sick or the boiler goes, that may no longer be an option. (Read more, here: 5 Ways To Pay Down Your Mortgage-Without Going Broke.)

The Bottom Line

Adjustable-rate mortgages have gotten a bad rap ever since the 2008 financial crisis that resulted in record foreclosures and short sales. However, even in an environment where interest rates are near all-time lows, and people are much more risk averse, there is a place for an ARM. That doesn't mean an adjustable-rate mortgage is the right product for everyone, but it is a good option for some. If you don't plan to stay in your home for too long, expect to see a substantial increase in your earnings potential or you have the means to pay off the loan before it resets than an adjustable-rate mortgage may be an ideal option for you. To mitigate any surprise issues, before you take out an adjustable rate mortgage make sure you understand the terms of your loan, the interest rate and when the rate will readjust.

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