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I'm looking to purchase a home for my primary residence, and I've talked to several mortgage lenders. They all are strongly recommending a 10-year Adjustable Rate Mortgage (ARM), because they say that interest rates are very high right now and are likely to come down in the next 10 years, at which point I can refinance with a fixed rate.

Obviously I'm a little nervous that the mortgage rates could stay up. And I know the lenders have their own incentives and may not be fully forthcoming with the downsides.

Can you help me assemble a list of the pros and cons of using an ARM right now?

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    "they say that interest rates are very high right now" You should not trust "them", you should look at historic data on rates. Right now rates are still lower than average. They just aren't "setting new records for how low they are" low.
    – Ben Voigt
    Commented Nov 23, 2022 at 19:43
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    infogram.com/1peg7nvdnl9e9qtm75ryenpw2msll1ewld0
    – Ben Voigt
    Commented Nov 23, 2022 at 19:49
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    Interest rates are still historically quite low. IIRC, normal rates are more like 8% and high rates are 20%. Commented Nov 24, 2022 at 12:19
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    @BenVoigt we could just as easily say that historically, the trend is for rates to raise suddenly and significantly when there is an inflation crisis, and then gradually lower the rest of the time. There are significant political pressures to lower rates any time that inflation and unemployment numbers allow it; tech companies want to be able to borrow cheaply and they have a lot more power than ordinary citizens with money sitting in HISAs. Commented Nov 24, 2022 at 16:21
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    I agree with the lenders. The rates climbed recently due to pandemic recovery, the war, etc. They are likely to go down sometime in the next 10 years. Of course, whenever you predict the future you risk being wrong. Whatever you do, be vigilant on the rates and refinance as soon as they drop. Don't wait. I waited during the pandemic and regret it now. Commented Nov 24, 2022 at 20:33

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they say that interest rates are very high right now and are likely to come down in the next 10 years, at which point I can refinance with a fixed rate.

Or not. And then what? Is the rate difference you're saving worth the risk? You can always refinance if the rates go down, you don't even need to wait for 10 years. But what if they don't?

With ARM you're betting on the the interest rates in X years, how confident are you to make that bet? That's the con.

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The advantage of an ARM is that the initial interest rate may be lower than what you would have to pay for a fixed rate.

Suppose the bank calculates that, under present market conditions, they could make a reasonable profit on a mortgage if they charged, say, 5%. (I'm just making up numbers for an example. I'm not claiming that any numbers I use here are real.) But inflation is running high. Maybe it will continue to be high. Maybe it will go even higher. So making a loan at 6% would be very risky for the bank. Sure, they'd make money at that rate today. But a mortgage typically lasts 15 to 30 years. Who knows what will happen in that time? So if they're going to guarantee a rate for 30 years, to be safe they pad it a little, and charge maybe 6% or 7%.

But with a variable rate mortgage, they can offer a lower rate today and if things change increase the rate. So maybe they're willing to offer a loan at 6%. If things get worse the rate can go up to 7% or 8%. If things get better it might come down to 5%.

From the bank's point of view, an ARM reduces their risk.

From the borrower's point of view, an ARM increases his risk. Instead of the bank committing to a certain rate, it could go up. Sure, it could come down, too, but this doesn't help him much. If interest rates came down enough, he could refinance the loan. It's nice that the rate could come down and he gets the lower rate without the time and expense of refinancing, but this is a minor advantage. The bank is shifting the risk from themselves to the borrower.

If they offer a lower initial rate than fixed rates that are available, it may be a good risk to take. You may accept the risk that your payment will be higher next year in exchange for a lower payment this year. After all, it might not go up, in which case you win. A major cause of increasing loan rates is inflation, and if inflation is high your income may be going up, too, so you may have more nominal dollars next year to pay it.

If fixed rate loans are available at the same rate as the initial rate on an ARM, I don't see any reason to go with the ARM. (Well, unless other terms of the loan make it more desirable -- some other fee is lower or whatever.)

Also, I would carefully check what the rules are for determining the variable rate. I once foolishly took out a car loan with an initial rate of 9.9% but where the contract said that the bank could change the rate to anything they wanted up to 20%. After a year they jacked it up to 15% and the next year to 19%. I had no real recourse because I had signed a contract agreeing to that. I paid the loan off as quickly as I could and since then I've read the paperwork more carefully. Most ARMs I've seen since then tie the rate to something outside the bank's control and that is verifiable, like some index or the "rime rate" or some such. Maybe there are laws about this now.

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  • banks are known to manipulate rate indices but not by a lot - more like 0.05% Commented Nov 24, 2022 at 12:23
  • @user253751 Sure. Like one common index used is based on the average rate banks are charging for loans. So any one bank could boost that index by charging more for their own loans. A typical small bank probably wouldn't change it enough to matter, but a big bank might have a lot of influence on it. And if it's the banks that are collecting the data, I wouldn't be surprised if they manipulate the numbers a little.
    – Jay
    Commented Nov 24, 2022 at 16:35
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From a risk assessment point of view, an ARM reduces lenders risk and increases the borrowers risk.

Any plan to avoid the increase by refinancing is foolish. Typical ARM loans are less than 1% “cheaper” than a corresponding fixed rate, frequently around .5%. If you refinance as soon as rates start changing you’ll loose out on the refinance cost, if you wait until just before your rates increase it will be too late and rates will have already risen. At that point the adjusted rate is STILL going to better than a fixed rate, so you might as well stick with it.

That doesn’t make them a bad idea. As the above indicates, at any point in time, they are generally the best rate available.

The most common mitigation for the borrowers increased risk is a plan to close the loan during the fixed rate period. If you purchase a home with a 7 year ARM and believe you can and will sell in 4 years, then it doesn’t matter what the interest rates are in 7 years, the loan will have been paid off.

For something you plan on keeping, ARM is all risk, and the benefit isn’t that great.

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