Are Adjustable Rate Mortgages (ARMS) Risky Loans?

Last Updated on March 29, 2023 by Mark Ferguson

ARMs or an adjustable-rate mortgage is a loan where the interest rate is fixed for a certain amount of time, but the rate can adjust after that fixed period expires. For example, an ARM may have a fixed period of 5 years at 3% interest. For the first 5 years the loan interest rate will be 3% but after the five years are up the interest rate can adjust up or down depending on what the current interest rates are. I have used many ARMs to invest in real estate and for my personal houses that I live in, but is an ARM a good loan? I think ARMs are a great option for many people but you must be careful with them and some ARMs are set up in a very risky way. ARMs were also a contributor to the last housing crash but it is really tough to get a loan now like they were before the crash.

What is an Adjustable Rate Mortgage (ARM)?

Adjustable-rate mortgages or ARMs have gotten a bad name in the last past because many people used them to buy houses they could not afford before the housing crisis. An ARM is a loan that starts with a low-interest rate, but the interest rate can increase after a set period of time. A 5/30 year ARM is a 30 year loan with an initial rate that is fixed for the first five years but can increase on the sixth year. There is a cap for how much the interest rate can increase after the adjustment period, and a minimum it can decrease. An ARM can adjust up or down depending on where interest rates are when the loan adjusts. On my loans, the rate might start at 4.5 percent, but could raise up to 8 percent (investment properties). The rate cannot increase more than 1 percent in any given year.

Most ARMs will have a 3, 5, 7, or 10 year fixed period. In the past, there were ARMs with 6 month fixed rate periods and the interest would jump after those 6 months were up. These were some incredibly risky loans and many consumers had no idea what they were getting themselves into. Currently, it is almost impossible to get a loan like that as the government really tightened up regulations after the last crash.

How does a mortgage work?

Is an ARM a good loan?

Lower rates

An ARM usually has a lower interest rate than a fixed mortgage. A 30 year fixed rate mortgage would have the same rate for 30 years. If the rate on a 30 year fixed rate loan is 3%, the rate on a 5/30 ARM might be 2.5% or lower. The real advantage is when interest rates are higher. When rates were 5% the rate on an ARM might be 4%, which can save hundreds of dollars a month and thousands of dollars a year.

When rates get really low, in the 2 and 3% range an ARM may not have much lower of a rate than a 30-year fixed loan. There may be no advantage to using ARMs when rates are super lown and you may want to have that super-low rate locked in as long as you can.

Portfolio lenders

Another reason I use an adjustable rate mortgage is they are one of the few options available from my local lender. I use a portfolio lender who lends their own money on loans; they do not sell the loans to other companies or investors like most banks do. My portfolio lender offers a 5 year and 7 year ARM as well as a 15 year fixed loan. The 5/30 year ARM has the lowest payment, lowest interest rate and works perfect for my cash flow strategy. The reason I use a portfolio lender is many lenders will not loan to investors when they have more than four mortgages. My portfolio lender will lend on as many loans as I can qualify for, but I must use their limited loan options. Portfolio lenders can also be a great option for getting a loan on a home that needs repairs.

I much prefer a 30-year loan to a 15-year loan because you pay so much more into the 15-year loan in the first 15 years. I could use that money to invest instead and make way more money than paying off a 3% loan faster. If I want a 30-year loan, the only option I have is to get an ARM that could adjust in the future.

Commercial loans

I also own commercial properties and most commercial loans do not offer long-term fixed-rate mortgages. They often have loans with 3, 5, or 10 year fixed periods and some will have a longer variable period on the loan. Commercial loans also have lower loan terms and 30-year terms will be very hard to find. YOu may be able to get 20 or 25-year terms.

Are ARMs riskier than a fixed-rate loan?

ARMs have gotten a bad name due to the high number of loans that were foreclosed on during the housing crisis. The reason so many people lost their homes with an ARM was they qualified on the low initial interest rate. When the rate on the adjustable-rate mortgage went up after five, three or even one year, the homeowner could no longer afford the payment. If you are thinking of getting an adjustable-rate mortgage, make sure you can afford the payment increases even if you think you will have the loan paid off by then. Do not depend on being able to refinance to get yourself out of the loan. If you buy homes in a smart way by getting a good deal, and the market does well you can most likely sell if the rate adjusts, but if the market changes the wrong way you may find yourself in trouble if you stretched yourself too thin!

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An adjustable-rate mortgage may be cheaper than a fixed-rate loan

The interest rate on an ARM is lower in the beginning of the loan than a fixed-rate loan most of the time. The ARM may be cheaper than a fixed rate loan even if you do not pay off the ARM right away and the rate increases. During the five years that the ARM is at its low rate, you are saving money every month over the fixed-rate loan. Even if you don’t pay off that ARM and the rate adjusts, it would still take years for the total cost of the ARM to catch up to the fixed-rate loan. If you reinvest the money you are saving from the ARM and make a higher return on that investment than the interest rate on the loans that will make you even more money. It usually takes 8 years and an ARM adjusting to its maximum amount, before the fixed-rate loan saves you money.

Again, this assumes the ARM has a much lower rate than a fixed-rate loan.

Conclusion

An Adjustable-rate mortgage is a great loan, especially when you have few other options. Be smart when deciding to use an ARM and it can be a great tool for any investor. The biggest mistake you can make is not being prepared for a payment increase if you are not able to pay off the loan or refinance. If you are prepared to hold the loan, you should be just fine.