Is an Option or other ARM Right for You?

Wondering whether an adjustable rate mortgage (ARM) is right for you? It might be, especially if you don’t plan to stay in the home for more than three to five years. People buying starter homes or those with jobs that require frequent moves can be good candidates for ARMs. So are buyers with tarnished credit because ARMs sometimes have easier qualifying requirements. But others may also be good candidates.

Different types of ARMs

Once you start shopping for an ARM the first thing you’ll realize is that it comes in many varieties. Rates on traditional ARM products are usually low initially. But they have a tendency to increase rapidly. If you’re looking for the lowest payment, an Option ARM is worth investigating. Just understand that over time, it’s possible for the balance on your loan as well as your monthly payment to increase. A Hybrid ARM is a combination adjustable/fixed rate product. The interest rate will likely be higher initially than the rate on a traditional ARM. But later it’ll change into a rate that will be fixed for a term of 3, 5, 7, or 10 years.

If the value of homes in the area in which you intend to purchase is questionable, think very carefully before looking at an Option ARM. Those low payments usually won’t cover principal and interest; a situation that can result in negative equity or owning more than the home is worth. In such a housing market, you may wish to consider instead a hybrid or traditional ARM.

As a way to get you into a home, you may be offered an ARM with a low introductory rate. And although the rate is tempting, especially if your bad credit is keeping you from getting more favorable rates, it’s important to remember that you won’t have that low rate for very long. It’ll adjust after the introductory period expires. If you don’t think you’ll be able to afford the higher payments when the payment adjusts, this may not be the right choice.

Even though you intend to refinance into a loan with better rates before the first adjustment date, understand that this doesn’t always happen. If you can’t improve your credit score in the interim, or your home doesn’t appreciate as anticipated, you may not be able to refinance. Like it or not, waiting may be a better option because it gives you time to save more for a down payment and work on improving your credit.

Option ARMs carry risk

An Option ARM is a mortgage product that gives you various payment options. For example, you have the option to make a monthly payment equal to the amount of interest due. You have the option to make just the minimum payment required. You have the option to make a payment that is fully amortized (so your mortgage balance actually decreases). And you have the option to make what’s called an accelerated payment. This last option is amortized over 15 years.

While the flexibility of this type of ARM sounds appealing, it can result in a situation where the home a borrower purchased is worth less than the amount owed on the mortgage. Also, since rates can adjust as much as 65%, mortgage payments have the potential to be considerably higher. The increase is compounded if the borrower also experiences a rise in property tax rates, and/or homeowner’s insurance or PMI.

It’s best to consider this type of loan product only if your cash flow is not steady because it gives you the ability to make higher or lower payments as needed. If the most you’ll be able to afford is the minimum payment, seriously consider a different type of mortgage. Also consider something else if your budget requires you to make the same payment each month.