The Risks of an Adjustable-Rate Mortgage Explained
In recent years, many people have been attracted to adjustable-rate mortgages, or ARMs, because of the low initial interest rates. These mortgages have become increasingly popular due to the potential for lower monthly payments in the short term. However, ARMs are not without risks. In this article, we will explore the potential downsides of ARMs and help you make an informed decision when choosing a mortgage.
How ARMs Work
An adjustable-rate mortgage is a home loan that offers a low introductory interest rate for a set period of time, typically three to seven years. After this initial period, the interest rate on the mortgage can fluctuate based on market conditions. As a result, your monthly mortgage payments can also change.
The interest rate on an ARM is typically tied to an index, such as the prime rate or the London Interbank Offered Rate (LIBOR). When interest rates rise, your mortgage rate will also increase, resulting in higher monthly payments. Conversely, when interest rates fall, your mortgage rate will decrease, resulting in lower monthly payments.
The Risks of ARMs
While ARMs can be attractive due to their low initial interest rates, they are not without risks. Here are some potential downsides to consider:
- Interest Rate Volatility: One of the biggest risks of ARMs is interest rate volatility. If interest rates rise, your mortgage payments will increase, and you may struggle to keep up with your monthly payments. This can put you in a difficult financial position and even lead to foreclosure.
- Payment Shock: ARMs can also lead to payment shock, which is a significant increase in mortgage payments when the introductory period ends. This can be especially challenging if your income has not increased enough to cover the higher payments.
- Negative Amortization: Some ARMs have a feature known as negative amortization, where the monthly payments are not enough to cover the interest owed. This can result in a growing balance on your mortgage, even as you make payments each month.
- Refinancing Risks: If you plan to refinance your mortgage before the initial period ends, you may be subject to prepayment penalties. Additionally, if interest rates have increased, you may not be able to refinance at a lower rate, resulting in higher monthly payments.
Is an ARM Right for You?
While ARMs can be a good choice for some borrowers, they are not right for everyone. Here are some factors to consider when deciding if an ARM is right for you:
- Financial Stability: If you have a stable income and can handle potential increases in mortgage payments, an ARM may be a good option. On the other hand, if you are worried about how you would manage if your mortgage payments increase significantly, you may want to consider a fixed-rate mortgage.
- Future Plans: Consider your future plans when deciding whether an ARM is right for you. If you plan to sell your home before the initial period of the ARM ends, it may be a good option. However, if you plan to stay in your home for the long-term, a fixed-rate mortgage may provide more stability.
- Tolerance for Risk: ARMs are a riskier option than fixed-rate mortgages, and you need to be comfortable with fluctuations in your mortgage payment. If you do not have a high tolerance for risk, a fixed-rate mortgage may be a better option.
Bottom Line
Adjustable-rate mortgages can be a good choice for some borrowers, but they are not without risks. If you are considering an ARM, take the time to carefully evaluate your financial situation and your long-term plans. Consider working with a mortgage adviser who can help you make an informed choice that aligns with your goals and risk tolerance.