Adjustable-rate mortgages (ARMs) aren't as popular as they used to be. But if you look at the numbers, many homebuyers really ought to consider getting one.
Real estate agents will tell you that the typical homebuyer only stays in a home for five to seven years before moving on. First-time homebuyers in particular are likely to get a "starter" home for a few years, then move up to a larger one as their income and/or family expands.
This raises the question: if you're only going to be in a house for five to seven years, why get a 30-year mortgage?
Saving money with an ARM
ARMs are a great money saving tool for people who aren't planning to make a long-term commitment to a house, condo or other property they're buying. The interest rates are substantially lower than on a standard 30-year fixed-rate mortgage - about a full percentage point lower on a 5-year ARM, according to current Freddie Mac figures - so you can save a lot of money on mortgage interest.
You can get ARMs in a variety of lengths between one and 10 years, so you can find one that matches the length of time you plan to own the home.
ARMs are basically 30-year mortgages with a variable interest rate. If you have a 7-year ARM, the mortgage rate is fixed for the first seven years, then readjusts periodically after that to bring it more in line with current interest rates.
The reason the interest rates on ARMs are so much lower than fixed-rate mortgages is because the lenders don't have to worry about getting stuck with a low-interest loan if rates go up over the next decade or two. But if you're going to be a short-time owner, long-term rates aren't going to be an issue for you either.
Why ARMs got a bad rap
ARMs got a bad reputation during the runup to the subprime mortgage crisis because they were used in a lot of ways that made them risky, turning them into so-called "exotic" mortgages. These provided low payments at first, but would increase dramatically when it came time for the loan to reset, unless the mortgage was refinanced. This worked fine as long as home values were rising, but once they started to fall, borrowers could no longer refinance and were stuck with the new, higher payments.
These days, high-risk, "exotic" ARMs are all but extinct. When their rates reset, it's according to a predictable formula that limits how much and how fast your rate can increase, if you should end up owning the home longer than you expect. You'll also need to put up some kind of a down payment, which will provide a cushion against possible price declines.
There's still a risk with an ARM that if home prices take another big drop you could get stuck with the loan and the house if you're unable to sell or refinance. But as long as you make sure that any rate resets are capped at a reasonable maximum interest rate, your payments should remain at an affordable level. In fact, your payments could remain the same or even decline if overall interest rates hold steady or fall, since ARM resets are pegged to prevailing market rates at the time.