Understanding Adjustable vs Fixed Rate Mortgages: Pros and Cons

When considering a mortgage, homeowners often explore various types, including adjustable rate mortgages (ARMs) and fixed rate mortgages (FRMs). Both options come with unique advantages and disadvantages. Here’s a detailed exploration of each, focusing on the benefits and potential drawbacks of adjustable mortgage rates.

Advantages of Adjustable Rate Mortgages (ARMs)

Lower Initial Interest Rates: One of the primary advantages of ARMs is their lower initial interest rates compared to fixed rate mortgages. For instance, a 7/1 ARM can offer a rate up to two percentage points lower than a 30-year fixed rate mortgage, making it an attractive option for many homebuyers. This lower initial rate can help reduce the monthly payments and potentially facilitate the purchase of a larger house if the borrower can be confident about their future earnings.

Disadvantages of Adjustable Rate Mortgages (ARMs)

Rate Uncertainty: The most significant drawback of ARMs is the rate uncertainty. The interest rate can fluctuate over the term of the mortgage, leading to unpredictable monthly payments. This instability can cause financial stress and uncertainty for homeowners, especially if rates rise dramatically.

Rate Caps: ARMs generally come with interest rate caps that limit how much the rate can increase or decrease. However, these caps do not protect borrowers from significant fluctuations, as the rate can still rise above the cap, potentially leading to higher payments. For example, if the index on which the ARM rate is based increases by a large margin, the borrower may find themselves paying significantly more than initially anticipated.

When ARMs Are a Good Option

For Wealthier Earnings: ARMs can be a viable option for individuals who are expecting a significant increase in their income in the near future. If a borrower anticipates paying off the mortgage through increased income, the lower initial rate can facilitate a faster paydown process. Additionally, the ability to pay some of the principal in the event of an adjustable rate increase can help reduce the overall mortgage term.

Economic Bonuses: People who receive large one-time bonuses or financial gains at the end of the year may also benefit from ARMs. By using a portion of these bonuses to pay down the principal, borrowers can reduce their mortgage term, thereby saving on interest costs.

Minimizing Risk with an Adjustable Mortgage

Paying Down Principal: To mitigate the risks associated with adjustable rate mortgages, borrowers can adopt a strategy of direct principal payments. Each month, a portion of the payment can be dedicated directly to the principal, reducing the overall mortgage term. For example, if a borrower’s mortgage is $3,000 per month, they could pay $2,750 toward the monthly payment and an additional $250 toward the principal, thereby reducing the term of the mortgage from 30 years to approximately 24 years.

Strategic Payment Planning: To implement this strategy, borrowers should call their bank and ensure that a portion of their extra payment is applied directly to the principal. Here’s a practical example: Cook more dinners at home and skip Starbucks coffee to free up extra funds for direct principal payments. Every dollar reduces the true cost of the home by accelerating the mortgage payoff timeline.

Conclusion

Mortgage options vary widely, and the choice between a fixed rate mortgage and an adjustable rate mortgage depends on individual financial circumstances and market conditions. While ARMs offer lower initial rates, the potential for future rate increases and financial uncertainty must be carefully considered. On the other hand, fixed rate mortgages provide long-term security and predictability, but at a higher initial cost.

Key Takeaways:

Lower initial interest rates make ARMs an attractive option. Rate uncertainty and caps present significant financial risks. Paying down the principal can reduce the mortgage term and save on interest costs. ARMs can be a good option for those expecting a significant income increase or receiving end-of-year bonuses.

To ensure financial security, borrowers should carefully evaluate their options and consult with a financial advisor to determine the best course of action for their specific situation.