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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.

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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.

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.

By clicking “See Rates”, you will be directed to LendingTree. Based on your creditworthiness, you may be matched with up to five different lenders in our partner network.

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Mortgage

Here are the Best Low- or No-Down-Payment Mortgages

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.

Should you refinance with your current lender?
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It’s an often-cited rule of thumb, but you don’t actually need a 20% down payment to get a mortgage. In fact, you can get a home loan with little money down, and even a no-down-payment mortgage.

Assuming you’re financially prepared for all of the other responsibilities of homeownership, consider the following mortgage programs.

No-down-payment mortgage options

USDA loans

The U.S. Department of Agriculture (USDA) insures home loans made by approved lenders to eligible homebuyers in designated rural areas. As the program states, USDA loans were created to improve the quality of life in rural areas by giving families the opportunity to own a “modest, decent, safe and sanitary” home as their primary residence.

There’s no required minimum down payment or mortgage insurance, but there are guarantee fees. A portion of the fee is paid upfront and is 1% of the loan amount; the other portion is 0.35% of the loan amount and is paid annually.

To be eligible, you must:

  • Have a low-to-moderate income for your area
  • Buy a home in a designated rural area
  • Have a preferred minimum 640 credit score
  • Have a maximum 41% debt-to-income (DTI) ratio

VA loans

The U.S. Department of Veterans Affairs (VA) also offers a no-down-payment mortgage option guaranteed through its VA loan program. These loans cater to active-duty military service members, veterans and eligible spouses, and are offered by private lenders.

Borrowers aren’t required to make a down payment, but there is an upfront funding fee — which ranges from 1.4% to 3.6% of the loan amount — to help offset the program’s costs to taxpayers. The loan must be used to purchase a primary residence.

To be eligible, you must:

  • Have a certificate of eligibility from the VA
  • Have a preferred minimum 620 credit score
  • Show proof of stable income
  • Have a maximum 41% DTI ratio

Low-down-payment mortgage options

Fannie Mae HomeReady® and Standard 97% LTV

Fannie Mae has two low down payment conventional loans: HomeReady® and Standard 97% LTV. The HomeReady® mortgage program is open to both first-time and repeat homebuyers, while the Standard option requires at least one borrower to be a first-time buyer.

Borrowers can’t earn more than 80% of their area median income (AMI) if applying for a HomeReady loan. Additionally, if all borrowers on either a HomeReady or Standard loan are first-timers, at least one of them must complete an online homebuyer education course.

Both programs also require private mortgage insurance (PMI) if you make a down payment of less than 20%, though PMI can be removed after you reach 20% equity.

To be eligible, you must:

  • Have a 620 credit score
  • Have a 3% minimum down payment
  • Have a maximum 50% DTI ratio

Freddie Mac HomeOne and Home Possible

Freddie Mac’s HomeOne mortgage is reserved for first-time homebuyers and doesn’t include any income restrictions. The Home Possible® loan is an option for first-time and repeat buyers with a low to moderate income.

Your income must not exceed 80% of the AMI for a Home Possible® loan. You may qualify without a credit score, but your minimum down payment rises from 3% to 5%. Cancellable PMI is required for borrowers who put down less than 20%.

There’s a homebuyer education requirement for both HomeOne and Home Possible® programs when all borrowers on the loan are first-timers.

To be eligible, you must:

  • Have a 3% minimum down payment
  • Have a minimum 660 credit score
  • Have a maximum 50% DTI ratio

FHA loans

The Federal Housing Administration’s (FHA) low down payment home loans require just a 3.5% contribution and a 580 credit score. You can also qualify for an FHA loan with a credit score of 500 to 579 if you have at least a 10% down payment. Other FHA loans, such as construction-to-permanent loans and 203(k) loans, have the same credit score and down payment requirements.

FHA loans require upfront and annual mortgage insurance premiums (MIP). The upfront premium is 1.75% of the loan amount; the annual premium ranges from 0.45% to 1.05%, is divided by 12 and paid in monthly installments as an addition to your mortgage payment. Borrowers who put down at least 10% only pay mortgage insurance for 11 years; putting down less means you’ll pay MIP for the life of your loan.

To be eligible, you must:

  • Have a 580 credit score and 3.5% down payment
  • Have a 500 to 579 credit score and 10% down payment
  • Borrow within your county’s FHA loan limits
  • Have a maximum 43% DTI ratio

Good Neighbor Next Door

The Good Neighbor Next Door program from the U.S. Department of Housing and Urban Development (HUD) allows homebuyers in certain public service professions to buy a home at a 50% discount. If you qualify for and use an FHA loan to buy a home, the down payment is only $100, instead of the minimum 3.5% that’s usually required.

Eligible borrowers must buy a home located in a HUD revitalization area and commit to live in the home for at least three years. They must also sign a silent second mortgage for the discounted amount, though no payments are required if all program requirements are met.

To be eligible, you must:

  • Be a full-time pre-K through 12th grade educator, emergency medical technician, firefighter or law enforcement officer
  • Buy a home in a HUD revitalization area
  • Qualify for a conventional, FHA or VA loan
  • Live in the home for at least three years

Pros and cons of no or low down payment

Pros

Cons

  • Buy a home sooner. It can take years to save up for a larger down payment. By contributing 0% down or the lowest possible amount, you can reach your homeownership goal in less time.

  • Avoid depleting your savings. If you limit how much money you contribute to your home purchase, you can leave some of your emergency savings intact. Lenders want to know that you can weather financial hiccups, such as a job loss or income reduction.

  • Start out with less equity. The less money you put down, the less home equity you’ll have initially. This means your ownership stake in your home is much smaller, which may lead to pocketing less money if you need to sell in a few years.

  • Take out a larger mortgage. A no- or low-down-payment mortgage means you’ll be close to financing 100% of your home’s purchase price. A larger mortgage means a higher monthly payment amount.

  • Pay more in interest over time. The more money you borrow, the higher your interest rate typically will be. This also means you’ll pay more in interest over the life of your loan.

FAQs about mortgage down payments

Yes, there will be closing costs to pay on your home loan. Mortgage closing costs can range from 2% to 6% of your loan amount. You can pay these costs out of pocket at the closing table, or ask your lender about a no-closing-cost mortgage. With this type of loan, your lender will either increase your mortgage rate or add the closing costs to your loan amount, instead of having you pay those costs upfront.

It depends on the type of mortgage. Conventional loans require private mortgage insurance when you put down less than 20%, and it can be canceled after you’ve built at least 20% equity in your home. All FHA loans require mortgage insurance premiums, but if you put down 10% or more, you can get rid of MIP after 11 years.

Reach out to your loan officer and real estate agent for help identifying any down payment assistance programs you might qualify for. You should also check with your state’s housing finance agency.

Many loan programs let you use monetary gifts from family members, friends and others to help cover your down payment, but there must be a specific paper trail for the gift. The donor will need to submit a gift letter to show that you won’t have to repay the money being gifted to you. Consult your lender for specific guidelines.

Yes, your down payment amount can affect your mortgage rate. The less money you put down, the riskier you can appear to lenders, and they can account for this risk by raising your mortgage rate.

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.

By clicking “See Rates”, you will be directed to LendingTree. Based on your creditworthiness, you may be matched with up to five different lenders in our partner network.

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Mortgage

5 Home Loans for People With Bad Credit

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.

You don’t need a perfect credit score to get a mortgage — there are home loans for people with bad credit. But before getting this type of mortgage, find out how a lower credit score affects your overall borrowing costs.

Buying a home with bad credit

It’s possible to buy a home with bad credit — you could have a credit score as low as 500 and still qualify for a mortgage. The lower your credit score, though, the fewer lending options you’ll have and the higher your mortgage rate will be.

FICO scores, the credit scores used by most lenders, typically range from 300 to 850. Having a lower credit score translates to higher risk for a lender, and vice versa. Any score 669 or lower is considered “fair” or “poor.” Here’s a breakdown:

  • Exceptional: 800 and higher 
  • Very Good: 740-799
  • Good: 670-739
  • Fair: 580-669
  • Poor: 580 and lower 

Lenders like to see high credit scores because it exhibits an ability to manage debt, make on-time payments and use credit responsibly. Your creditworthiness will come into question if you plan on buying a home with bad credit, but it doesn’t have to hold you back from homeownership.

5 home loans for bad credit

Consider one of the following home loans for bad credit.

Fannie MaeHomeReady

Fannie Mae’s HomeReady mortgage program is an option for both first-time homebuyers and repeat buyers with limited access to down payment funds and a fair credit score. This conventional home loan has cancellable mortgage insurance for those who put down less than 20%, and gives borrowers the option to use boarder or rental income to help them qualify. If all borrowers on a loan are first-timers, at least one borrower is required to complete a homeownership education course.

Eligibility requirements include:

  • A minimum 620credit score
  • A minimum 3% down payment
  • A low- to moderate income

FHA Loans

Mortgages backed by the Federal Housing Administration (FHA) could be considered bad credit home loans because they make it easier for low-credit-score homebuyers to get a mortgage. FHA loans have a low down payment requirement, but you’ll pay mortgage insurance premiums (both upfront and annual) for the life of your loan. If you put down at least 10%, you can get rid of mortgage insurance after 11 years.

Eligibility requirements include:

  • A minimum 10% down payment for a 500-579 credit score
  • A minimum 3.5% down for a 580+ credit score
  • Borrowing within your county’s FHA loan limits

USDA loans

The U.S. Department of Agriculture (USDA) insures mortgages funded by approved lenders through the USDA home loan program. There’s no minimum required credit score, but a 640 score could help you get approved automatically if you meet employment and income requirements.

Eligibility requirements include:

  • No minimum required down payment
  • Meeting local income limits
  • Buying a home in a designated rural area

VA Loans

The Department of Veterans Affairs (VA) also offers bad credit home loans through approved lenders for active-duty service members, veterans and eligible spouses. The VA doesn’t have a specific credit score requirement, but lenders may require a minimum 620score. No down payment is required. Additionally, most borrowers will have to pay an upfront funding fee to offset the cost of VA loans to taxpayers.

Eligibility requirements include:

Non-qualified mortgage loans

The loans discussed above are all qualified mortgages, meaning they meet certain requirements that establish a borrower’s ability to repay a loan. There are also non-qualified mortgage (non-QM) loans, which have more wiggle room for high-risk borrowers, such as accepting credit scores below 500.

Eligibility requirements include:

  • Demonstrating your ability to repay the loan
  • A minimum down payment up to 20%
  • A maximum debt-to-income ratio of up to 55%

How to get a home loan with bad credit

Use the following list of tips as a resource to help you get a bad credit home loan.

  • Avoid applying for new credit. A new auto loan, credit card or personal loan application means you’ll have new inquiries on your credit reports, which can drop your credit score.
  • Dispute any credit report errors. Finding and disputing inaccurate information on your credit reports could improve your credit score and help lenders see you as a less risky borrower.
  • Pay your bills on time. Your payment history makes up the biggest chunk of your credit score at 35%, according to FICO. Making on-time payments can help boost your score and demonstrate your creditworthiness as a borrower.
  • Lower your outstanding debt load. Pay down your credit card and loan balances. Lenders don’t want to see that your income is stretched too thin to afford a mortgage. Keep your credit usage below 30% of your maximum credit limit across each of your accounts.
  • Don’t close any accounts. Closing old accounts, especially credit cards, shortens your overall credit history and can negatively impact your credit score.
  • Have your rent payments reported to the credit bureaus. As long as you’ve been maintaining an on-time rental payment history, having your rent payments reported to the bureaus may boost your score.
  • Make a larger down payment. A larger down payment can compensate for a lower credit score. Don’t completely drain your cash reserves, though. Keep three to six months’ worth of living expenses in a savings account for emergencies.
  • Pay for mortgage points. If you have the extra cash, consider buying mortgage points to lower your interest rate and overall loan costs. One point is equal 1% of your loan amount and can lower your rate by up to 0.25%.

Should you get a bad credit home loan?

Home loans for bad credit come with more risk for lenders, so you can expect to pay more as a borrower. Crunch the numbers with a mortgage calculator to help you determine whether to move forward with a bad credit mortgage or wait until your credit profile improves.

Here’s an example of how your credit score can affect your costs on a 30-year, fixed-rate mortgage:

 620 credit score760 credit score
Mortgage rate4.84%3.25%
Loan amount$200,000$200,000
Monthly payment
(Principal and interest)
$1,054.17$870.41
Total interest cost$179,501.82$113,348.55

As you can see, improving your score from “fair” to “very good” could amount to a mortgage payment that is nearly $184 less each month, saving you more than $2,200 each year and more than $66,000 in interest over the term of your mortgage.

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.

By clicking “See Rates”, you will be directed to LendingTree. Based on your creditworthiness, you may be matched with up to five different lenders in our partner network.