If you're planning the purchase of your first home (or are selling an existing home and purchasing another), you may be concerned about recent reports that the Federal Reserve will soon be raising interest rates. If so, you're not alone -- during the weeks after this announcement, mortgage applications dropped by more than 25 percent. In this type of lending environment, is it ever a good idea to purchase a home using an adjustable-rate mortgage (ARM)? Read on to learn more about these products and when an ARM may make sense during a time of rising rates.
What is an ARM?
Many mortgages are fixed-rate -- which means the interest rate will stay the same for the life of the loan, with interest payments amortized over this period. Over time, a proportionally larger share of your monthly payment will go toward the principal balance. If you have a fixed-rate mortgage, the only time your monthly payment should change during the life of the loan is if you've created an escrow account for your property taxes or homeowners insurance.
ARMs, as the name indicates, have an adjustable interest rate rather than a fixed one. Unlike credit cards, which can change interest rates frequently and without much warning, most ARMs will give you plenty of notice before raising your payment amount. However, because these adjustable rates are tied to market rates, refinancing an ARM that has reset during a time of rising rates may leave you stuck with a much higher payment than you'd have had if you took out a fixed-rate mortgage when you purchased your home.
Can an ARM be a good idea when interest rates are rising?
Despite the risk of an ARM resetting to a much higher interest rate and leaving you unable to refinance into a lower-rate loan, these mortgages can still be a good financial tool in many situations.
Although interest rates are currently set to rise for the foreseeable future, it's likely this recovery will be slow -- and you may find that even after your ARM resets, your interest rate (and payment) is still lower than you'd be experiencing with a fixed-rate loan. Those concerned about a sudden rate hike that may make the monthly payment unaffordable can investigate ARMs with caps on the amount the interest rate (or payment) can increase each year.
These mortgages can also be ideal for those who are considering a shorter fixed-rate mortgage (like 15 or 20 years instead of 30) or who are planning to pay off the mortgage early. By taking out an ARM with a rate that doesn't reset for 5, 7, or even 10 years, you should be able to have your mortgage mostly paid off before the rate ever rises. For more information, talk to a professional like McHenry Savings Bank.