An adjustable-rate mortgage is a home loan with an interest rate that rises and falls as interest rates shift. As Debt.org notes, these home loans comprised less than 3 percent of the market at the end of 2009, but they made up 14 percent of the dollar volume on home loan applications in 2018. While they may not be the most popular choice, borrowers are clearly giving this form of financing a second look. Should you? Reviewing a list of adjustable-rate mortgage pros and cons can help you decide.
Adjustable-Rate Mortgage Pros and Cons
Borrowers who opt for a fixed-rate mortgage know from the start what their interest rate and payment will be because they stay the same throughout the life of the loan. In contrast, people who choose an adjustable-rate mortgage must accept a certain amount of unpredictability because their interest rate can change.
Why do some people take the gamble? What makes others shy away? These loans offer a specific combination of benefits and drawbacks. Understanding adjustable-rate mortgage pros and cons makes it easier to determine if this type of home loan is a good fit for you.
The Advantages of Adjustable-Rate Mortgages
Why would borrowers welcome the inevitable uncertainty that comes with an adjustable-rate mortgage? After all, if interest rates soar, the loan’s interest rate and your mortgage payment will rise accordingly, which could put serious pressure on your finances. As The Smart Investor points out, adjustable-rate mortgages may be a gamble, but they come with several advantages:
- Lower initial interest rates. The initial interest rate on an adjustable-rate mortgage is generally lower than the one on a comparable fixed-rate loan. Borrowers enjoy this rate for a set period of time. Then, the rate shifts periodically for the remainder of the loan’s term. A lower initial interest rate can make buying a home more affordable. It’s especially appealing for borrowers who expect to be in a better financial situation soon or who plan to sell before the interest rates start to shift.
- Lower monthly payments at the start. A lower initial interest rate means that you start with a lower monthly payment. Since the size of your mortgage payment factors into calculations on how much you can afford to borrow, a smaller monthly payment can translate into the ability to borrow more, which can increase your purchasing power and make buying the home that you really want more feasible.
- Automatic benefits when interest rates fall. If mortgage rates fall, borrowers with a fixed-rate mortgage have to refinance to secure a lower rate. With an adjustable-rate mortgage, your interest rate will go down automatically.
- Caps that limit your risk. If you opt for an adjustable-rate loan, you can use caps to limit your risk. A variety of interest rate and payment caps are available that can limit the incremental or total increases in your rate, your payment, or both.
The Disadvantages of Adjustable-Rate Mortgages
As NerdWallet indicates, adjustable-rate mortgages do come with certain disadvantages that any borrower considering this form of financing needs to weigh carefully:
- Your mortgage payments could increase. Once the initial rate expires, your rate and payments will reflect the market. They can go down. They can also go up.
- The unexpected may happen. Borrowers who gamble on an adjustable-rate loan often believe that they’ll either be in a stronger financial position or they’ll sell the property before the lower initial rate period ends, but plans can change. If the unexpected happens, you may find making payments during the adjustable-rate period of the loan difficult.
- Adjustable-rate mortgages are complicated. Adjustable-rate mortgages are complex financial instruments. Understanding all the terms and their implications can be a challenge.
- There may be a prepayment penalty. If interest rates start to soar, you can refinance into a fixed-rate mortgage. However, many adjustable-rate loans include a prepayment penalty that can add to the cost of refinancing.
Do you want to know more about adjustable-rate mortgage pros and cons? Turn to the loan experts at PrimeLending of Kansas City. We delight in helping our clients achieve their housing goals by matching them with the right financial product for their situation. Contact us today to get started.