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When Does an Adjustable-Rate Mortgage Make Sense?

Editorial Note: The content of this article is based on the author’s opinions and recommendations alone. It has not been previewed, commissioned or otherwise endorsed by any of our network partners.

When you’re shopping for a mortgage, the rates you’ll see quoted for adjustable-rate mortgages look awfully tempting. In nearly every case, they’ll be significantly lower than a standard 30-year fixed-rate mortgage.

That’s because these rates only apply for a short period of time — typically going up significantly after a period with that lower rate.

However, adjustable-rate mortgages have their uses. Below, we argue for the two instances when it makes sense to borrow an ARM for a home purchase: if you’re planning to pay off your loan quickly, or if you plan to sell your home before the fixed-rate period ends.

What makes an ARM different?

An adjustable-rate mortgage is a home loan that has an interest rate that changes multiple times over the term of the loan, which is usually 30 years. That’s different from fixed-rate mortgages, where the interest rate stays the same for the entire period.

Most ARMs begin with a fixed interest rate for a period of five or seven years. Once the fixed-rate period ends, the interest rate becomes variable and adjusts periodically.

You can easily see how long the initial fixed rate period will last by looking at how the loan is marketed. If you borrow a 5/1 ARM, for example, your interest rate would be fixed for five years and then adjust annually thereafter for the remaining 25 years of the mortgage term.

The new, adjustable rate is partly determined by an index, which is a broad measure of interest rates. Some ARMs come with interest rate caps, meaning there’s a limit to how high the rate can adjust.

Because an ARM typically has a lower rate than a fixed-rate mortgage — for the first few years, at least — it can help you buy a home and start paying down your mortgage at a lower monthly cost than you could manage with a fixed-rate mortgage.

Let’s take a look at the cost differences between a 30-year fixed-rate mortgage and a 5/1 ARM during the first five years.

 30-year fixed 5/1 ARM

Loan amount

$200,000 $200,000

Interest rate

3.82% 3.51%

Monthly payment
(Principal and interest)


$934.19 $899.21

Principal paid after 5 years

$4,327.55 $4,499.45

Interest paid after 5 years

$6,882.77 $6,291.02

As shown above, the 5/1 ARM is less costly over the first five years of the mortgage term. Due to having a lower interest rate, you could save nearly $35 on your monthly payment and nearly $600 in interest. You’d also pay down just over $170 of your outstanding principal balance.

What to expect after the first adjustment

Your lender may have a limit in place for how much your interest rate can increase when it adjusts for the first time after the fixed-rate period ends. The initial adjustment cap could be 2% or even 5%, according to the Consumer Financial Protection Bureau.

Based on the example above, a 2% interest rate bump would push the 5/1 ARM’s principal and interest payment from $899.21 to $1,136.83 — a monthly difference of $237.62. This drastic jump in the monthly payment amount could push the mortgage into an unaffordable territory.

Cases when an ARM makes more sense

Adjustable-rate mortgages don’t suit every homebuyer, but there are certain instances when they make more sense:

  1. When you plan to pay off your mortgage very quickly.
  2. When you’re planning to sell your home in a few years.

Getting rid of your mortgage at a rapid pace

An ARM’s lower initial interest rate can work in your favor if you have the means to pay off your mortgage in a much shorter time frame than what a 30-year term calls for.

That’s exactly what Meg Bartelt, CFP and founder of Flow Financial Planning, and her husband did when they bought their home. Although the couple’s cash was largely tied up in investments, they had enough to buy their home outright. Still, selling the investments for the home purchase would’ve pushed them into a much higher tax bracket and increased their tax burden.

“By taking an ARM, we can spread the sale of those investments out over five years, minimizing the income increase in each year. That keeps our tax bracket lower,” Bartelt said. “We avoided increasing our marginal tax rate by double digits in the year of the purchase of our home.”

Another reason the ARM also worked in her family’s favor was the fact that they could continue to pay the mortgage past that initial five years if they chose to do so. “The interest rate won’t be as favorable as if we’d initially locked in a fixed rate,” she admitted, “but that option still exists, and having options is power.”

Selling your home before the rate adjusts

Another way ARMs can provide benefits to homeowners? If you won’t live in the home for long. Buying the home and then selling it before the initial fixed-rate period expires could provide you with a way to access the lowest possible rate without having to weather the eventual rise in your mortgage payment. When the interest rate adjusts, it’s more likely than not that it will significantly increase.

“ARMs are typically best for those who are fairly certain they won’t be in the house for a long period of time,” said Cary Cates, CFP and founder of Cates Financial Planning. “An example would be a person who has to move every two to four years for their job.”

His suggestion is to view an adjustable-rate mortgage as a way to pay “tax-deductible rent” — if you already know you don’t want to stay in the house for more than a few years.

“This is an aggressive strategy,” Cates explained, “but as long as the house appreciates enough in value to cover the initial costs of buying, then you could walk away only paying tax-deductible interest, which I am comparing to rent in this situation.”

You’re obviously not actually paying rent, but you can mentally frame your mortgage payment that way, Cates added. However, the risk is owing the difference between what your home sold for and your outstanding mortgage balance, if your home’s value hasn’t appreciated enough to cover what you spent to buy it.

Pros and cons of an ARM

ARM benefits ARM drawbacks
  • Interest rates typically start out significantly lower than fixed-rate mortgages
  • Lower initial principal and interest payments
  • You can more quickly pay down your principal during the fixed-rate years
  • Will typically include a cap on how high your interest rate can go when it adjusts

  • The interest rate isn’t predictable after the fixed-rate period ends
  • Influenced by market conditions even after they’re first borrowed
  • Your principal and interest payments can increase dramatically, causing your mortgage to be unaffordable
  • The only way to get rid of an ARM (outside of paying it off) is to refinance or sell your home

“The main advantage of an ARM is the low, initial interest rate,” Bartelt said. “But the primary risk is that the interest rate can rise to an unknown amount after the initial fixed period of just a few years expires.”

Homebuyers can enjoy extremely low interest rates for one, three, five, seven or 10 years, for example, depending on the term of their adjustable-rate mortgage. But borrowers have no control over the interest rate after that period.

When the index that the ARM is tied to rises, so does your interest rate. The rate could rise to levels that make your monthly mortgage payment unaffordable.

The variable nature of the interest rate makes it difficult to plan ahead, as the principal and interest portion of mortgage payment will no longer be stable.

“Imagine at the end of year five, rates start going up and your mortgage payment is suddenly much higher than it used to be,” said Mark Struthers, CFP, CFA and founder of Sona Financial.

“What if your partner loses their job and you need both incomes to pay the mortgage?” Struthers asked. In this situation, you could be stuck if you don’t have the credit score to refinance and get away from the higher rate, or the cash flow to handle the extra cost. “Once you get in this spiral, it is tough to get out,” he said. “The spiral just gets tighter.”

It’s easy to assume that you’ll be able to refinance into a fixed-rate mortgage before your first rate adjustment, but remember that just as you had to qualify for your original mortgage, you’ll again need to meet the qualifications to replace that loan with a brand-new one.

Read our explainer for a thorough rundown of how to refinance your mortgage.

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Questions to ask before borrowing an ARM

Before applying for an adjustable-rate mortgage, be sure to reach out to multiple lenders and ask questions like:

  • How long is the initial fixed-rate period? How does that compare with another mortgage option, and is it worth taking on a riskier mortgage to get the initial fixed rate?
  • How often will the ARM adjust after the initial fixed-rate period?
  • Is there a limit to how low the interest rate can drop?
  • How high can the interest rate go? How does that affect the monthly mortgage payment?
  • If the mortgage hits the maximum interest rate, would I still be able to comfortably afford the monthly payment, based on my debt-to-income ratio?

The bottom line

Borrowing an adjustable-rate mortgage may seem like a feasible idea, especially when you consider how much you can save during the early years of your mortgage. But it’s critical to consider whether the benefits outweigh the risks.

If you’re concerned about affordability, be sure you’ve developed a plan to refinance your mortgage or sell your home before the interest rate begins adjusting. Still, depending on your specific situation, your finances and your plans for the first few years following your home purchase, you could make an ARM work for you.

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

Kali Hawlk
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Kali Hawlk is a writer at MagnifyMoney. You can email Kali at [email protected]

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Crissinda Ponder is a writer at MagnifyMoney. You can email Crissinda here

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Mortgage

Should You Save for Retirement or Pay Down Your Mortgage?

Editorial Note: The content of this article is based on the author’s opinions and recommendations alone. It has not been previewed, commissioned or otherwise endorsed by any of our network partners.

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On the list of financial priorities, which comes first — paying off your mortgage or saving for retirement? The answer isn’t simple. On one hand, owning a home with no mortgage attached to it provides long term security knowing you’ll have a place to live with no monthly payment except property taxes and insurance. However, you’ll also need income to live on if you plan to retire, and how much you save now will have a big impact on your quality of retirement life.

We’ll discuss the pros and cons of whether you should save for retirement or pay down your mortgage, or maybe a combination of both.

Pros of paying down your mortgage vs. saving for retirement

The faster you pay your mortgage off, the sooner you own the home outright. However, there are other benefits you’ll realize if you take extra measures to pay your loan balance off faster.

You could save thousands in long-term interest charges

Most homeowners take out a 30-year mortgage to keep their monthly payments as low as possible. The price for that affordable payment is a big bill for interest charged over the 360 payments you’ll make if you’re in your “forever” home.

For example, a 30-year fixed $200,000 loan at 4.375% comes with a lifetime interest charge of $159,485.39. That’s if you never pay a penny more than your fixed mortgage payment for that 30-year period. Using additional funds to pay down your mortgage faster can significantly reduce this.

Even one extra payment a year results in $27,216.79 in interest savings on the loan we mentioned above. An added bonus is that you’ll be able to throw your mortgage-free party four years and five months sooner.

You’ll build equity much faster

Thanks to a beautiful thing called amortization, lenders make sure the majority of your monthly mortgage payment goes toward interest rather than principal in the beginning of your loan term. Because of that, it’s difficult to make a real dent in your loan principal for many years. You can, however, counteract this by making additional payments on your mortgage and telling the lender to specifically put those payments toward your principal balance instead of interest.

Not only do you pay less interest over the long haul with this strategy, but you build the amount of equity you have in your home much faster. And to homeowners, equity is gold — you’re closer to owning your home outright, and equity can also be a resource if you need funds for a home improvement project or another big expense.

You can access that equity as your financial needs change by doing a cash-out refinance or by taking out a home equity loan or home equity line of credit (HEL or HELOC).

You won’t lose your home if values drop

When you contribute extra money into a retirement account, there is always the risk that you’ll lose some or all of the money you invested. When you contribute money to paying off your mortgage, even if the values drop, you still have the security of a place to live, and are increasing the equity in the home, no matter how much it’s ultimately worth.

Making extra payments ensures you’ll eventually have a debt-free asset that provides shelter to you and your family, regardless of what happens to the housing market in your neighborhood.

Cons of paying down your mortgage vs. saving for retirement

There are some cases where paying down your mortgage faster might actually hurt you financially. Before adding extra principal to your mortgage payments, you’ll want to make sure you aren’t doing damage to your financial outlook with an extra contribution toward your mortgage payoff.

You might end up paying more in taxes

The higher interest payments you make during the early years of your mortgage can act as a tax benefit, so paying the balance down faster could actually result in you owning more in federal taxes. If you are in a higher tax bracket in the early (first 10 years) of your mortgage repayment schedule, it may make sense to focus extra funds on retirement savings, and let your mortgage interest deduction work for you. Of course, everyone’s tax situation is different, so you’ll have to decide (with help from an accountant ideally) if it makes sense to itemize your taxes in order to claim mortgage interest payments as a deduction.

You won’t get to enjoy the return on your paydown dollars until you sell

The only real benchmark for figuring out the value of paying down your mortgage is to look at how much equity you’re gaining over time. However, the equity doesn’t become a tangible profit until you actually sell your home. And the costs of a sale can take a big bite out of your equity because sellers usually pay the real estate agent fees.

Home equity is harder to access

The only way to access the equity you’ve built up is to borrow against it, or sell your home. Borrowing against equity often requires proof of income, assets and credit to confirm you meet the approval requirements for each equity loan option. If you fall on hard financial times due to a job loss, or are unable to pay your bills and your credit scores drop substantially, you may not be able to access your equity.

Pros of saving for retirement vs. paying down your mortgage

Depending on your financial situation and savings habits, it may be better to add extra funds monthly to your retirement account than to pay down your mortgage. Here are a few reasons why.

You may earn a higher return on dollars invested in retirement funds

The growth rate for a stock portfolio has consistently returned more than housing price returns. The average return in the benchmark S&P stock fund is 6.595% for funds invested from the beginning of 1900 to present, while home values have increased just 0.1% per year after accounting for inflation during that same time period.

Assuming your portfolio at least earns 7%, if you consistently invest your money into a balanced investment portfolio, you can expect to double your money every 10 years. There aren’t many housing markets that can promise that kind of growth.

Retirement funds are generally easier to access than home equity

Retirement funds often give you a variety of options for each access, with no income or credit verification requirements, and only sufficient proof of enough funds in your account to pay it back over time. For example, a 401k loan through the company you work for will just require you to have enough vested to support the loan request, and sufficient funds left over to pay it off over a reasonable time.

Just be cautious about making a 401k withdrawal, which is treated totally differently than a loan. You aren’t expected to pay it back like you would a 401k loan, but you could get hit with taxes and penalties.

Cons of saving for retirement vs. paying down your mortgage

You’ll need to weather the ups and downs of the market

Most people who have invested money in the stock market or tracked the performance of their 401k over decades have stories about periods when the value of those investments dropped substantially. While the 7% return on investment is a reliable long term indicator how much your retirement fund might earn, the path to that return is hardly linear.

For example, if you were considering retirement between 1999 and 2002, you may have had to delay those plans when the S & P plummeted over 23% in value in 2002. If you look at each 10-year period since the 1930s, every decade has been characterized by periods of ups and downs.

Calculating the benefit of paying down your mortgage vs. saving for retirement

If you’re torn as to what to do with that extra cash or windfall, let’s look at an example of someone who has an extra $200 to put into either their nest egg or their mortgage each month for the next 30 years.

For this scenario, we’re going to assume their retirement account earns an average 7% rate of return and that their mortgage loan balance is $200,000.

Here’s how much they’d save:

Savings From Paying $200 per Month Down on Your Mortgage
Years PaidMortgage Interest SavingsExtra Equity in HomeTotal Interest Savings and Equity Built Up
10 years$6,040$30,039$36,079
20 years$28,529$76,529$105,058
22 years 6 months$50,745$200,000$250,745

One thing you may notice about the mortgage savings chart — it includes how much extra equity you’re building. Often only the mortgage interest savings is cited when people look at how much you save with extra payments, but that ignores the fact that you’re building equity in your home much faster as well. So not only do you save over $50,000 in interest with your extra contribution, you replenish $150,000 of equity that was used up by your mortgage balance.

As you can see, adding that extra $200 to their mortgage principal each month saved them about $200,000 in the long haul — but the real savings don’t stop there.

By adding an extra $200 to their mortgage payment each month, this borrower turned their 30-year loan into a 22-and-a-half year loan and became mortgage debt-free seven years faster.

That means, in addition to saving $50,000 in interest savings and gaining $200,000 of equity, they also no longer have a mortgage payment. That frees up $998.57 per month that they can now use as discretionary income. That’s an extra $89,871 they could potentially save over that 7.5 year period.

When you add that to the $250,745.41 they saved on mortgage interest and earned in home equity, they’re looking at a total savings of $340,616.

That gives the mortgage paydown a $54,000 net positive edge over saving that extra $200 for retirement, as you can see in the table below.

Savings From Contributing $200 per Month to a Retirement Fund
Years PaidRetirement Balance
10 years$34,404
20 years$102,081
30 years$235,212

The one caveat for this retirement calculation is we assumed the saver was starting at a $0 investment balance. If they already had a healthy balance in their nest egg, they might actually come out in better shape than paying down their mortgage.

There are clearly benefits to each option, and you should consider running your own calculations with your real numbers to get the best answer for yourself.

Paying down your mortgage and saving for retirement at the same time

There’s a fair case to be made for both paying down your mortgage and saving more for retirement, but why choose? If you’re somewhat on track with your retirement savings goals, and like the idea of having your mortgage paid off quicker, you could allocate a certain amount to each.

Pick a number you feel comfortable paying to your principal every month, and then to your 401k, and put it on autopilot for a year. Any time your income increases, or you get bonuses, divide up the amount between principal pay down and retirement additions.

Let’s look at what happens if you evenly divide up your $200 per month between investing your retirement and paying down your mortgage. We’ll use the same $200,000 loan at 4.375% referenced above, and look at the lifetime results.

Savings From Paying $100 Down on Your Mortgage Until Paid Off
Years PaidInterest SavingsExtra Home EquityTotal Interest Savings and Equity Built Up
10 years$3,020$15,020$18,040
20 years$14,265$38,265$52,350
25 years$30,534$200,000$230,534
Savings From Contributing $100 to a Retirement Fund for 30 Years
Years PaidRetirement Balance
10 years$17,202
20 years$51,401
30 years$117,607

Balancing the $100 investment in both strategies still yields a six-figure retirement balance after 30 decades, a debt-free house after 26 years, and shaves off $30,000 in mortgage interest expense. If you don’t like putting all your eggs into one financial basket, this may balance the risks and rewards of each option.

Final thoughts

Looking at the short term and the long term may provide you with the best framework for making a good decision about how to spend dollars on retirement versus extra mortgage payments. Be wary of any financial professional that tells you one path is absolutely better than another.

Having a stable source of affordable shelter is equally as important as having enough income to live when you retire, so a balanced approach to paying down your mortgage and savings for retirement may help you accomplish both goals.

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

Denny Ceizyk
Denny Ceizyk |

Denny Ceizyk is a writer at MagnifyMoney. You can email Denny here

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Life Events, Mortgage

What Is Mortgage Amortization?

Editorial Note: The content of this article is based on the author’s opinions and recommendations alone. It has not been previewed, commissioned or otherwise endorsed by any of our network partners.

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One of the biggest advantages of homeownership versus renting is each mortgage payment gradually pays off your mortgage and builds equity in your home. The difference between your home’s value and the balance of your loan is home equity, and your equity grows with each payment because of mortgage amortization.

Understanding mortgage amortization can help you set financial goals to pay off your home faster or evaluate whether you should refinance.

What is mortgage amortization?

Mortgage amortization is the process of paying off your loan balance in equal installments over a set period. The interest you pay is based on the balance of your loan (your principal). When you begin your payment schedule, you pay much more interest than principal.

As time goes on, you eventually pay more principal than interest — until your loan is paid off.

How mortgage amortization works

Understanding mortgage amortization starts with how monthly mortgage payments are applied each month to the principal and interest owed on your mortgage. There are two calculations that occur every month.

The first involves how much interest you’ll need to pay. This is based on the amount you borrowed when you took out your loan. It is adjusted each month as your balance drops from the payments you make.

The second calculation is how much principal you are paying. It is based on the interest rate you locked in and agreed to repay over a set period (the most popular being 30 years).

If you’re a math whiz, here’s how the formula looks before you start inputting numbers.

Fortunately, mortgage calculators do all the heavy mathematical lifting for you. The graphic below shows the difference between the first year and 15th year of principal and interest payments on a 30-year fixed loan of $200,000 at a rate of 4.375%.

For the first year, the amount of interest that is paid is more than double the principal, slowly dropping as the principal balance drops. However, by the 15th year, principal payments outpace interest, and you start building equity at a much more rapid pace.

How understanding mortgage amortization can help financially

An important aspect of mortgage amortization is that you can change the total amount of interest you pay — or how fast you pay down the balance — by making extra payments over the life of the loan or refinancing to a lower rate or term. You aren’t obligated to follow the 30-year schedule laid out in your amortization schedule.

Here are some financial objectives, using LendingTree mortgage calculators, that you can accomplish with mortgage amortization. (Note that MagnifyMoney is owned by LendingTree.)

Lower rate can save thousands in interest

If mortgage rates have dropped since you purchased your home, you might consider refinancing. Some financial advisors may recommend refinancing only if you can save 1% on your rate. However, this may not be good advice if you plan on staying in your home for a long time. The example below shows the monthly savings from 5% to 4.5% on a $200,000, 30-year fixed loan, assuming you closed on your current loan in January 2019.

Assuming you took out the mortgage in January 2019 at 5%, refinancing to a rate of 4.5% only saves $69 a month. However, over 30 years, the total savings is $68,364 in interest. If you’re living in your forever home, that half-percent savings adds up significantly.

Extra payment can help build equity, pay off loan faster

The amount of interest you pay every month on a loan is a direct result of your loan balance. If you reduce your loan balance with even one extra lump-sum payment in a given month, you’ll reduce the long-term interest. The graphic below shows how much you’d save by paying an extra $50 a month on a $200,000 30-year fixed loan with an interest rate of 4.375%.

Amortization schedule tells when PMI will drop off

If you weren’t able to make a 20% down payment when you purchased your home, you may be paying mortgage insurance. Mortgage insurance protects a lender against losses if you default, and private mortgage insurance (PMI) is the most common type.

PMI automatically drops off once your total loan divided by your property’s value (also known as your loan-to-value ratio, or LTV) reaches 78%. You can multiply the price you paid for your home by 0.78 to determine where your loan balance would need to be for PMI to be canceled.

Find the balance on your amortization schedule and you’ll know when your monthly payment will drop as a result of the PMI cancellation.

Pinpoint when adjustable-rate-mortgage payment will rise

Adjustable-rate mortgages (ARMs) are a great tool to save money for a set period as long as you have a strategy to refinance or sell the home before the initial fixed period ends. However, sometimes life happens and you end up staying in a home longer than expected.

Knowing when and how much your payments could potentially increase, as well as how much extra interest you’ll be paying if the rate does increase, can help you weigh whether you really want to take a risk on an ARM loan.

The bottom line

Mortgage amortization may be a topic that you don’t talk about much before you get a mortgage, but it’s certainly worth exploring more once you become a homeowner.

The benefits of understanding how extra payments or a lower rate can save you money — both in the short term and over the life of your loan — will help you take advantage of opportunities to pay off your loan faster, save on interest charges and build equity in your home.

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

Denny Ceizyk
Denny Ceizyk |

Denny Ceizyk is a writer at MagnifyMoney. You can email Denny here

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