Cash-strapped millennials looking to keep interest-rate costs down are opting for adjustable-rate mortgages (ARMs) instead of the more traditionally popular fixed-rate mortgages.
ARMs are particularly attractive for young homeowners who do not plan to retain property long term. Experts say the best way to select an ARM is to match the fixed period to the time the buyer plans to be in the home. For example, millennials planning to move where their jobs take them within a few years might find a 3/1 ARM provides a rate advantage in the short term.
Know a millennial thinking of trying an ARM? Here’s what they should consider:
- Fluctuating rates. Although interest rates have been relatively stable recently, if they tick up mortgage payments will go up as well. Assume going in that rates are going to rise so you can plan accordingly.
- Understand the caps. Under the qualified-mortgage rules of the 2010 Dodd-Frank Act, lenders must assess ARM borrowers at the highest potential rate over the first five years of the loan, rather than the initial rate, to ensure they can afford the loan if rates increase. When rates reset after the initial loan period, most ARMs are capped at two percentage points per adjustment. There’s also a six-percentage point cap on increases over the life of the loan.
- Know the terms. In addition to a cap, each ARM has an index or benchmark interest rate upon which adjustments are based. That index is commonly the prime rate or the Libor (London Interbank Offered Rate). Each ARM also has a margin, which is the percentage interest rate, commonly two percentage points, added to or subtracted from the index when the loan adjusts. The index benchmark is variable, but the margin is constant throughout the life of the mortgage. Those unsure of how these loan works in a given situation should consider consulting with a financial adviser.