An adjustable-rate mortgage (ARM) is riskier than a fixed-rate mortgage because its interest rate and monthly payments can increase over time after an initial fixed period. This means borrowers face payment uncertainty and the risk of higher costs if market interest rates rise, which can lead to unaffordable payments, default, or foreclosure. In contrast, a fixed-rate mortgage has a stable interest rate and predictable monthly payments for the entire loan term, which makes budgeting and long-term financial planning easier and less risky.
Why ARMs are Riskier
- ARMs start with lower initial rates but after a fixed period (e.g., 5, 7, or 10 years), the interest rate can adjust annually based on market conditions, potentially increasing payments significantly.
- The borrower assumes the risk of rising interest rates, unlike fixed-rate mortgages where the lender bears this risk.
- Higher future payments can strain finances, especially if income is not stable or rates increase sharply.
Impact of Rate Increases
- A rate increase causes higher monthly payments, which could lead to difficulty in making payments or the need to refinance.
- ARMs often have caps limiting how much the rate can rise each adjustment and over the loan’s life, but increases can still be substantial.
- The unpredictability of future payments makes ARMs harder to plan for compared to fixed-rate mortgages.
Borrower Considerations
- ARMs can be beneficial for borrowers who plan to sell or refinance before rate adjustments begin.
- Borrowers need a financial cushion to handle possible payment increases.
- Qualifying for ARMs may be harder due to stricter requirements reflecting the risk.
In summary, the riskiness of adjustable-rate mortgages lies in their variable interest rates that can lead to higher, unpredictable payments, whereas fixed-rate mortgages provide stability and predictability in payments.
