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When you consider loans for housing and other things, you may come across terms like “fixed rate” and “adjustable rate” as you search. Many people are attracted by the lower rates offered on adjustable-rate loans. This is especially true for long-term loans, like mortgages. Before you dive right in, though, it’s a good idea to learn a little bit about the two loan types, so you can make better-informed decisions about which loan type is best for you.

What is an Adjustable Rate Mortgage?

An adjustable-rate loan is usually offered for mortgages. They may be available for other long-term types of loans, but to be attractive to lenders, they need multiple opportunities to adjust rates along the way – something 30-year mortgages provide.

As a result, most of the time when you hear about an adjustable-rate loan it will be in connection with a mortgage loan. Let’s explore what it is and why it matters to you.

Adjustable-rate mortgages are mortgage loans in which a lower initial interest rate is offered for a specified term while providing the lender the opportunity to adjust your rate at pre-defined intervals. For the most part, this operates at a 5/1 ARM (adjustable-rate mortgage). Though, in all honesty, there are 3/1, 7/1, and 10/1 ARMs as well.  What that means is that after five years, the bank can adjust your interest rates according to various factors, including the current “going rate” for mortgage interest. Once the initial five-year period ends, most lenders adjust annually.

However, there are other terms available for ARMs including 5/5 which means that the initial rate is in effect for the first five years but then the rate will adjust to a rate that will carry it through the next five years. This process will repeat until you’ve paid the ARM in full or refinanced.

The thing about adjustable-rate mortgages is that they rarely work in favor of the buyer. Recent years have been rare exceptions to this rule in which people who took out mortgages five years ago are now enjoying the bounty of record-low interest rates, so they are more likely to enjoy a decrease in interest rates for the next five years.

Taking Advantage of Market Conditions

However, because current interest rates are at or near record lows and have been for many months. The expectation is that these interest rates will rise in the future making adjustable-rate mortgages now a little riskier for those who consider them.

That doesn’t mean they are always a bad idea. In fact, many people find a lot to love about ARMs in highly specific situations.

For instance, the following examples are times when an adjustable rate may be the preferred way to go when considering mortgage loans for your home.

  • Perhaps you have a bond that will mature in five years giving you a lump sum of cash or monthly payments that will free up wiggle room in your budget. If this is the case, an adjustable-rate mortgage may be ideal.
  • If you plan to refinance within five years for a fixed-rate mortgage, then this might be an option to consider, saving you money on the front-end of the mortgage payments and allowing you to cash out equity in your home quickly to end things like private mortgage insurance payments with a larger down payment.
  • You believe you will sell your home within five years. Some people purchase homes seeking to make improvements then sell the home for healthy profits later. This practice can be highly profitable, especially if you’re living in the home while improving it and an adjustable-rate offers a lower initial interest rate that is good news for you.
  • You’re in the military and plan to relocate within the next five to 10 years. This may have you in the area for the first adjustment, but help you avoid a potentially catastrophic later adjustment if the interest rate blows up on you in the meantime.
  • You plan to pay off the home within the first five to seven years. This is another time when adjustable rates allow you to pay less interest on your home. It can be a risk though. If you intend to pay your mortgage off early, make sure there are no penalties for doing so with the mortgage company.
  • There are very real and pervasive expectations that fixed-rate mortgage interest rates will decrease in the coming years, so you can refinance to the lower fixed rate over time. A word of caution, though, is that current rates are extremely low and likely to increase in the near future. This particular expectation is a real gamble in the current financial market.

While there are several situations in which adjustable-rate mortgages do work out to benefit the buyer, there are many more when this does not. Adjustable-rate mortgages were a contributing factor to the mortgage crisis of 2007-2008. This is why it is doubly important to be aware of a few key terms if you have an adjustable-rate mortgage today.

Key Terms for Adjustable Rate Mortgages

Because most people are unfamiliar with the mortgage process and what it means to have an adjustable-rate mortgage, there are a few key terms you need to understand, including those listed below:

  • Initial cap. This is the amount your initial interest rate can increase during your initial rate adjustment. In most cases, the cap is between two and five percentage points. However, you will need to read the terms of your mortgage to be certain.
  • Subsequent cap. This is the periodic or annual cap or the maximum rate at which your interest rate can increase with each future adjustment. It is usually set around two percentage points. Again, check with your mortgage documentation to be certain.
  • Lifetime cap. Many ARM loans have a lifetime cap that places a maximum on the total number of points your interest rates can increase over the life of your loan. This rate is usually five percentage points but it may be higher.
  • Payment cap. The payment cap may be the most confusing of all terms to borrowers. It refers to the total allowable increase in your monthly ARM payment. While it might sound like a good thing, it does not impact the amount of interest you owe for your home. That means you could be paying too little each month and that your loan balance will increase rather than decrease as a result.
  • Benchmark index. This is the index that determines changes to adjustable-rate loans. The index may be tied to one of the following: maturity yields for one-year Treasury bills, the London Interbank Offered Rate, or the 11th District cost of funds index.
  • Adjustment frequency. Tells you how often the interest rate for your loan is adjusted after the initial “honeymoon” phase where the interest rate remains stagnant.
  • Teaser rate. Sometimes referred to as an introductory rate, this is the initial interest rate on your ARM that will remain in effect for the duration of your “fixed-rate” introduction.

The better you understand these terms, the better you understand the potential total costs of an adjustable-rate loan for your home.

Fixed-Rate Loans and Mortgages

If you’re looking for consistency and peace of mind, a fixed-rate mortgage loan is the way to go. It is true that you will pay more during the initial period for these types of loans. However, you do not have to worry about your interest rates increasing and suddenly pricing you out of your home five, six, or ten years down the road.

That weight or uncertainty is a huge burden to relieve yourself of. One that is better if you never take it upon yourself in the first place. The fact is that many people get talked into adjustable-rate mortgages without fully understanding the potential financial impact of doing so.

It only takes one small financial hit to devastate the best-laid financial plans. In recent years, we’ve experienced a national recession and mortgage crisis, a pandemic that has had far-reaching (and largely undetermined because we are still in the midst of it) financial consequences on families of all shapes and sizes. We do not yet know when the full extent of the financial fallout from the pandemic will be realized or what is looming next on the horizon.

With so many uncertainties in the world, fixed-rate mortgages give you something reliable you can depend on, no matter what else is going on. Can you imagine the financial realities of lost jobs, incomes, or businesses, while going through the upheaval of an adjustable-rate mortgage? Fortunately, we’re at record low-interest rates so people going through their adjustment period now are in luck. That luck is not likely to hold. With rates this low, the only conceivable direction for them to go is up.

A recent CNBC report stated that 41 percent of American households could not manage a $1,000 emergency with their savings. Can you imagine the devastation to your budget and financial planning if your monthly house note were to suddenly increase by $200-300 per month?

That is the conundrum home buyers face when comparing loans. Is it worth saving $70 a month for the first five years only to face a risk of ballooning interest rates five or more years down the road?

When are Fixed Rate Mortgages Wise?

In most situations, fixed-rate mortgages are the wiser financial option. There is a bit of a gamble when considering adjustable-rate mortgages. No one knows what the future holds. Five years sounds like a long time for wonderful financial things to happen. The reality is that everything can change in the blink of an eye or the spreading of a single germ.

People who do best with fixed-rate mortgages include the following:

  • Families who plan to live in their homes for many years.
  • People who view their homes as investments in the future for their family.
  • People who hope to pass on their homes to their children in the future.
  • People who prefer consistency, so they can make financial plans accordingly.
  • People who aren’t considering retiring or relocating anytime soon.
  • People who have stable jobs and careers and are looking for stability in their housing.

Almost everyone who is considering a home loan stands to benefit by choosing a fixed-rate mortgage rather than an adjustable-rate mortgage. There are rare exceptions to this general rule of thumb. However, with the current interest rates so low, many of those exceptions are not as effective as they may have been in days past.

In other words, if you’re not planning a fast flip on your property or relocation before your initial term expires, it is likely not in your best interests, in the current state of things, to consider an adjustable-rate mortgage.