Back in the day, when I was buying houses with mortgages, I had a soft spot for adjustable-rate mortgages (ARMs). Why? They offered a lower interest rate than a 30-year fixed-rate mortgage. Plus, it made sense to match the fixed-rate period with how long I planned to own the house. Considering most people own their homes for about 12 years, locking in a higher interest rate for 30 years seemed like overkill. It’s like buying a bus for a family of four.
Despite my reasoning, ARMs often get a bad rap. In fact, 90% to 95% of new or refinanced mortgages are 30-year fixed-rate ones. It’s easy to be wary of what you don’t know or have.
Even with the biggest and fastest Federal Reserve rate hike cycle in history, there’s no need to rush to pay off your ARM before it resets. Let me explain using my own ARM as an example. I’ve taken out or refinanced a dozen ARMs in the past.
Most ARM holders will be just fine once their introductory rate period ends. Here’s why:
- You’ll pay down your mortgage principal during your ARM’s fixed-rate period.
In 2014, I bought a fixer-upper in Golden Gate Heights for $1,240,000, putting down 20%. I chose a 5/1 ARM with a 2.5% rate, which gave me a $992,000 mortgage. I could have gone for a 30-year fixed-rate mortgage at 3.375%, but I didn’t want to pay a higher interest rate unnecessarily.
Fast forward to October 4, 2019, I refinanced the remaining $700,711 mortgage to a new 7/1 ARM at a rate of 2.625%. Again, I could have refinanced to a 30-year fixed-rate mortgage at 3.5%, but I stuck with the lower rate. Over the years, I made regular mortgage payments and sometimes put extra money towards the principal when I had some to spare. This way, I managed to reduce the principal by $291,289 over 5 years, a 29.3% decrease from the original mortgage balance.
- Your mortgage pay down momentum will continue.
Since refinancing $700,711 on October 4, 2019, I’ve managed to reduce the principal loan balance by an additional $284,711, bringing the current mortgage balance down to $416,000 today. This steady reduction in the mortgage balance is due to a few factors. A lower mortgage rate means more of the monthly payment goes towards paying down the loan. Despite my monthly mortgage payment dropping after the refinance, I kept it at the same level to pay down extra principal. And whenever I had extra cash, I continued to make additional payments towards the principal.
- Inflation rates will likely drop by the time your ARM resets.
Inflation and mortgage rates spiked in 2020 and 2021, peaking in 2022 before gradually declining. The Consumer Price Index (CPI) peaked at 9.1% in mid-2022 and now stands at around 3.3% in mid-2024. It would be surprising if CPI were still above 3.5% by mid-2025.
- There’s a mortgage rate reset cap and lifetime cap.
My ARM’s interest rate caps limit the maximum increase allowed per annual rate adjustment for the first year to 2%. So, in the worst-case scenario, my initial rate adjustment would take me from 2.625% to 4.625%. Even at 4.625%, my rate would still be 2.125% lower than today’s average 30-year fixed-rate mortgage.
- Your property likely appreciated in value.
Another reason not to rush to pay off your ARM is that your property probably increased in value during the introductory fixed-rate period. As your property’s value goes up, the impact of a higher mortgage rate after the reset becomes less significant.
- Your payment might be lower once the ARM resets.
When my ARM resets, my principal loan balance will fall to ~$381,000, 45% lower than my refinanced balance of $700,711 in October 2019. My payment will decrease by $569 to $2,245 a month despite a 2% increase in the mortgage rate to 4.25%.
So, if you’re one of the few who took out an ARM before mortgage rates shot up, congrats! Just like those who took out 30-year fixed-rate mortgages, you were also able to take advantage of cheap money to buy an asset that likely appreciated.
There’s no need to worry about paying off your ARM before the reset period begins. Chances are good that you’ll end up paying a similar mortgage amount or less once the reset starts.
I enjoy borrowing cheap money to buy a nice home to enjoy and profit from. As I get older, I equally enjoy paying down mortgage debt in a sensible fashion. I’ve always felt great paying off a mortgage, and I’m sure this home I purchased in 2014 will be no different.
Why do you think so many people continue to dislike ARMs? Is it simply because people don’t like things they do not understand or commonly encounter? Why wouldn’t people want to save money on mortgage interest expenses, improve their cash flow, and invest the difference? Why lock in a fixed-rate duration at a higher price for much longer than you plan to own your home?
