An adjustable rate mortgage (ARM) is a type of home loan with an interest rate that can change after an initial fixed period. The main feature of an ARM is its interest rate cap, which limits how much the interest rate can increase. On average, the maximum increase in the first year is about 2%. This cap makes ARMs less risky than they might seem.
I’ve been a fan of ARMs since I bought my first property in 2003. Over 20 years later, I still think they’re a great choice. They can help homeowners save on interest compared to a 30-year fixed-rate mortgage. Even when mortgage rates rise, as long as they eventually return to a long-term declining trend during your ARM’s fixed period, you’re in a good position.
So, what exactly is an ARM? It’s a mortgage that offers a lower fixed rate for a certain period (1, 3, 5, 7, or 10 years), after which the rate can increase or stay the same. I usually go for 5/1 ARMs, which have a fixed rate for five years. This period offers a good balance between a low interest rate and duration security.
Many homeowners opt for 30-year fixed mortgages out of fear of a significant interest rate increase after the fixed rate period of an ARM. Banks also tend to push 30-year fixed mortgages because they offer higher profit margins. However, it’s important to remember that ARMs have a cap on how much the interest rate can increase during the initial adjustment period and over the lifetime of the loan. These caps may never come into play if certain economic indicators, like the 10-year Treasury bond yield or LIBOR, don’t increase.
I believe that mortgage interest rates will remain low for a long time due to low US Treasury rates, technological efficiencies, and globalization. As a result, I think it’s less optimal to take out a 30-year fixed mortgage with a 1% – 2% higher interest rate. An ARM can save you money compared to a 30-year fixed mortgage.
Let’s look at an example of my latest 5/1 ARM mortgage refinance. I refinanced a $981,000 mortgage with a 2.625% interest rate and a monthly payment of $4,318. The new mortgage is $850,000 at 2.375% with a monthly payment of $3,303.55. I paid down a little over $130,000 in principal to qualify.
The maximum my payment can increase to is $4,098 in the 6th year (the first year of adjustment), equivalent to a 2% interest rate hike to 4.375%. In the seventh year, my monthly payment could rise to $4,955 based on a 6.375% interest rate. The maximum lifetime interest rate increase is 5% from my initial base level, or 7.375%. This 2%/2%/5% lifetime interest rate increase is standard for all ARM holders.
Even if we reach a 7.375% interest rate for a 5/1 ARM in our lifetimes, paying $5,400 a month isn’t a big deal. My mortgage used to cost $6,800 a month 10 years ago when my principal balance was greater and my initial interest rate was closer to 5.25%.
Here are some reasons why you shouldn’t worry about hitting your interest rate caps:
- After five years, you’ve paid down about 10% – 12% of your original principal balance, which means 10 – 12% less interest to pay.
- You can "save the difference" in interest or cash flow savings with your 5/1 ARM payment versus if you took out a 30-year fixed mortgage. After 60 months of saving the difference, you’ll have a nice cash buffer in case you have to pay a higher interest rate.
- You can always pay down extra principal over the years. If you’re not satisfied with the automatic monthly mortgage pay down, you can always come up with a plan to pay down extra principal each month, quarter, or year during your fixed rate period.
In my experience, an ARM is a better choice for several reasons:
- You will likely have a chance to refinance at some point before the fixed rate period is over.
- You already know the worst-case scenario for your monthly payments. Once you know the worst-case scenario, you will no longer be surprised if it happens.
After 13 years of being an ARM holder for various properties, I’ve saved around $500,000 in interest expenses so far. Each year that goes by, I will probably save another $30,000 – 40,000 in interest expense by borrowing with an ARM than with a 30-year fixed mortgage. This is real money that can be used to live a more comfortable life or reinvest.
Despite taking out a 7/1 ARM in 2020 and seeing mortgage rates shoot higher in 2022 and 2023, I have no regrets. I’m confident by the time my ARM adjusts in 2027, mortgage rates will be back down to trend. By then, I’m also confident property prices will be much higher that paying a higher payment won’t be a big deal.
