It’s advice worth following.
- You might snag a lower initial interest rate on an adjustable-rate mortgage.
- But these loan products are risky, so borrowers should proceed with caution.
- Make sure you ask yourself if you can afford any increased rates down the line.
With mortgage rates on the rise this year, many home buyers are trying to find ways to lower their borrowing costs. And one way to do so — at least initially — is to opt for an adjustable-rate mortgage, or ARM, rather than stick to a fixed-rate loan.
With an adjustable-rate mortgage, you lock in an interest rate for a preset period of time. But once that time frame comes to an end, the interest rate on your loan can change with market conditions.
Now, what this means is that the interest rate on your mortgage has the potential to go down, thereby resulting in lower monthly payments. But it could also go up. And so if you’re going to take out an adjustable-rate mortgage, it’s important to understand the risks involved.
In fact, financial expert Suze Orman urges borrowers to proceed with caution when taking out an ARM. And she insists that if you’re going to go this route, you must run through these key questions first.
1. What’s the maximum increase at the first adjustment?
The good thing about getting an adjustable-rate mortgage is that you’re guaranteed a period where your loan’s interest rate will stay the same. With a 5/1 ARM, for example, you can lock in an initial interest rate on a mortgage for a five-year period. From there, your rate has the potential to rise once a year. (That’s what the “5” and “1” represent, respectively.)
But once your loan’s interest rate has the potential to climb, it could go up a lot. Orman cautions that your mortgage rate could rise as much as 2 percentage points at its first adjustment.
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As such, if you’re going to take out an ARM, use a mortgage calculator to see what your new monthly payments will look like once that higher interest rate kicks in. If you can’t afford the number you see, it’s a sign an adjustable-rate mortgage is a bad idea.
2. What’s the maximum increase the next year, and the year after?
When you sign an adjustable-rate mortgage, you don’t just face a one-time increase. Rather, your loan’s interest rate has the potential to adjust once a year. So it’s important to run those numbers through a mortgage calculator as well to see what sort of payments you might be in for.
Keep in mind that with an ARM, there’s generally a cap on the amount of interest you can be charged. But Orman cautions the cap could be as high as 6 percentage points above your loan’s starting rate. This means that if you sign an ARM at 5%, you could end up with a rate as high as 11% down the line.
3. What if I can’t refinance to get out of an ARM?
Some people sign an ARM with the intent to refinance once their loan’s interest rate starts to climb. But you shouldn’t assume that will be an option for you.
If mortgage rates are up across the board at that time, refinancing may not make financial sense. And if your credit score happens to take a hit, you may not be in a position to snag a more competitive rate on a mortgage. You’ll need a backup plan in case refinancing isn’t an option (or a good one).
Taking out an adjustable-rate mortgage isn’t guaranteed to backfire on you — but it could. It pays to take Orman’s advice and address these key questions before moving forward with one.