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I would like to get a list of possible scenarios when it comes to refinancing that I might not have known or considered at the end of the adjustment period. I am new to mortgages and ARMs

I am currently looking at 2 mortgages at 4.5% from different lenders. The ARM is a 10/6 month variation. So far I can only think of regular closing costs of a mortgage if I pick the fixed rate and refinance in 10 years when the interest rate is lower.

  • However, with the ARM, would I just be paying a little over the lowest rate if the interest rate is lower?
  • What would make getting the fixed rate more appealing in 10 years' time?
  • Is it likely that I could get the ARM and still refinance in which case it doesn't matter what I pick now?
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    What will the interest rates be for the duration of the ARM? If you can't say, can you speculate on whether they're more likely to go up, or down? (Hint: hard to go down from zero). May 18 at 2:19

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This answer is US-centric and is based on the fact that the US government implicitly subsidizes the 30-year fixed rate mortgage. Other countries and other financial systems have different trade-offs that make adjustable rate mortgages more common and more attractive compared to fixed rate mortgages.

Taking out an adjustable rate mortgage amounts to a bet that you'll sell the house before the fixed term expires or that rates will decrease and you'll be able to refinance at a lower rate or just enjoy lower rates when the rate adjusts. Broadly speaking, if rates drop, you win and pay less over the mortgage term. If rates rise, you lose and pay more over the mortgage term.

If you expect that you're going to be moving in less than 10 years, it makes perfect sense to get the slightly lower initial rate that an ARM has over a fixed rate mortgage. The median US homeowner stays in their home for 13 years but there are significant regional differences. And that tenure was much shorter just a few years ago. If you're reasonably confident that you'll want to move before the rate resets, an ARM is an attractive choice because the rate will generally be a bit below the fixed rate.

If you expect that interest rates are going to decline, an ARM is advantageous as well. You can always refinance to the new, lower rate assuming you maintain your creditworthiness and your home maintains its value (of course, you can always refinance your fixed-rate mortgage as well, it's just that fixed rate mortgages will have a slightly higher rate than ARMs). And if you don't refinance, your rate will decline when your mortgage interest rate adjusts.

On the other hand, if interest rates increase, your payments may increase substantially. Although rates have gone up quite a bit in the last year, they're still at historically very low rates. Looking at the historical record, there is a lot more room for rates to increase than to decrease. And if rates go up, you may find that your payments after the first 10 years go up dramatically. Your ARM will specify a cap that your rate can't increase above but that's going to be several percentage points above what the initial interest rate is. If you're looking at, say, a 4.5% ARM right now, your cap might be 9%. If rates go up (and rates have been above 9% many times throughout history), would you be able to make the mortgage payment at a 9% rate? That would be a struggle for a lot of people.

For most people in the US, an ARM is a pretty poor bet. If you win, you do slightly better by getting a lower rate for whatever time you have the ARM. That's probably worth thousands of dollars for most transactions but not tens of thousands of dollars. If you lose, though, your losses can be far more than a few thousand dollars. If interest rates hit your cap, you could be looking at monthly payments that jump by $1,000 or more when your fixed rate term expires and continue at that value for the remaining years of your mortgage. There will be a cap on how much the rate can jump at each 6 month adjustment so it would likely take a couple of years to hit your overall cap but then you'd be stuck paying that higher amount for the remaining 16 or 17 years of your mortgage term (assuming a 30 year mortgage).

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    while you can of course refinance a fixed loan, you will have to pay a fee and it can be quite a lot, potentially nullifying any savings from refinancing. (though of course there are lots of deals where you get a bonus from refinancing which may offset these fees)
    – Aequitas
    May 18 at 3:48
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    The cost to refinance a loan in the US won't depend on the current loan you have and generally aren't particularly high-- there is a lot of competition for refinance business which keeps fees reasonably low. If rates drop half a point, you'd usually recoup any costs in a couple of years which is usually well worth it to lock in the lower rate. May 18 at 3:59
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    IMO: ARMs are really best for people who are financially independent, willing to gamble on rates, and can afford to lose on that bet. For most people, the stability of a fixed rate mortgage is really beneficial.
    – JimmyJames
    May 18 at 16:21
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    @R..GitHubSTOPHELPINGICE - Sure, but you'd have the same issue if you had a fixed rate mortgage and wanted to move. That's more a consideration for whether buying or renting makes more sense. At the end of 10 years of a 30 year mortgage, you'll have paid off a bit over 20% of the initial principal amount. Assuming you start with 10 or 20% equity, you'd only be underwater if housing prices fell by 30-40%. That's a pretty reasonable safety margin for most people. May 18 at 17:32
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    @JustinCave: You'd be stuck unable to move, but with a fixed predictable payment you know you can afford, not one that can balloon out of control. May 18 at 17:33
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The major risk with an ARM mortgage was front and center in the 2008 recession: that rates will begin adjusting up when you are unable to sell your house. The major advantage of a fixed interest rate is that you don't have any risk of your payment changing - you pay $1200 a month today, you pay that 20 years from now; and in fact that means you're effectively paying less per month 20 years from now (due to inflation).

If you take an ARM, and the interest rates fall, then you're fine; but if they rise (and I'd assume that they will rise, at least in the short term), then your payment in 10 years will start to climb. That might not be a big deal - maybe you're making a lot more then, or maybe you're figuring to sell - but if the perfect storm occurs, then you'll have the same problem many did in 2008.

In 2008, what happened was a lot of people lost their jobs at around the same time as housing prices peaked and then dropped. That meant that many people were underwater on their mortgages - which means you can't sell, and can't refinance. If you can't afford the higher payment, you'll be stuck.

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  • I like the first sentence, but for many it was worse than that. It wasn't bad timing or luck. The subprime loans had a low teaser rate and were indexed to LIBOR+5% or more. Rates would adjust up, no matter what. If you were unable to refinance or sell after the teaser rate period, you'd eventually lose your house. Enter HAMP, Loan Modifications, etc...
    – Paul
    May 18 at 22:05
  • Thanks for the first sentence. Could you clarify why they will be adjusting up when one is unable to sell the house? My reasoning is that the rates would go down when the situation is bad like being in a recession. I may not be able to sell as no one would want to buy but the Fed would like to get more people working and spending so they would lower the rate. May 19 at 16:01
  • @heretoinfinity The rates might eventually go down, sure, as they did in 2008 - but they will lag a lot. If rates go up, say, 5 points from their low, which is very possible - then the adjustable rate in however long will start adjusting up even if rates are going down (as they’d still be higher than now). This is what happened in 2008. And 2008 didn’t have as low of a basis to today, nor did they have a major inflationary event to force such a large change (this is more akin to the period after the S&L crisis).
    – Joe
    May 19 at 19:41
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Though usually not applicable in the US, one thing to keep in mind is that there can be limits on how much you can repay on a fixed loan (without paying an additional fee), so if you want to have this flexibility to pay back extra then you will not want to have a fixed.

Not sure if possible in the US, but you can also usually split your loan into two mortgages, one being fixed and one being variable. This allows you to have the ability to pay back extra while also having a lot of the loan locked in so you won't have to worry (as much) about rates rising to above what you can pay.

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    In the US, there are virtually no mortgages with prepayment penalties given the post-2008 regulation changes. You can (basically) always pay more if you want. May 18 at 3:49
  • ah ok thanks, I'm not the most familiar with the specifics in the US
    – Aequitas
    May 18 at 3:53
  • Thanks for mentioning the existence of the 2 mortgages outside the US. It is nice to learn what could be possible in the world of financing. May 19 at 16:00

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