ARMs present many more potential pitfalls than fixed-rate mortgages and you should be aware of all the risks involved before you sign off on the paperwork.
There are usually three reasons why one chooses an ARM instead of a fixed-rate mortgage:
- Bad Credit
- Lower Interest Rate
- Interest Rate Speculation
Let's take a look at the common pitfalls associated with each reason for choosing an ARM.
Bad Credit
Banks are more likely to give customers with bad credit an ARM because ARMs move the risk of interest rate fluctuations from the bank and onto the customer. In other words, it is less risky for the bank to issue an ARM because the customer is taking on more risk.
This may seem counterintuitive because the banks are forcing customers who have had trouble paying off debt in the past to take on more risk. However, this is the way banks operate!
If you are choosing an ARM because it is the only option the bank is giving you because of past credit problems, you should try to look at other banks to see if they are more lenient. Online banks are typically the most lenient when it comes to bad credit and Lending Tree will submit your application to four banks quickly and easily.
If you cannot find a bank willing to give you a fixed-rate mortgage you should have a large cushion between your mortgage payment and income every month. This money should be saved so that in the event your interest rate does go up, you don't run into the pitfall of not being able to make your mortgage payment.
Depending on how much risk you like to live with, you may also consider refinancing once your credit score improves.
Lower interest rate:
ARMs typically carry a lower interest rate for the same reason they are the only option for people with bad credit: the banks are rewarding you for taking on more risk.
People in this situation are setting themselves up for failure because they are stretching their budget to the point where they would not be able to make their ARM payment if the interest rate went up slightly. If you find yourself in this situation you have three options:
- Find a less expensive house
- Earn more money
- Hope that the interest rate goes down
Which brings us to the last reason people choose ARMs.
Interest Rate Speculation
If you are certain that the interest rate is going to be lower than the current rate the entire time you are paying off the mortgage, it would be unwise to lock in the currently high interest rate and you should therefore consider an ARM.
However, many people get trapped into the pitfall of reading an article and assuming they can predict interest rates. It is not that easy! Remember that you will be paying off your ARM for another 30 years and it is impossible to know what the interest rate will be that far in the future.
ARMs have worked great for many people, but they have also ruined many others credit history. The biggest pitfall of an ARM is that your mortgage payment is dependent on something you have no control over, which may or may not work to your benefit.
Before you buy your home, ask yourself why you are using an ARM instead of a fixed-rate mortgage. Then, figure out a plan that will alleviate your risk and ensure that you don't get trapped in any of these pitfalls!