Using an ARM Loan for a Starter Home: A California Mortgage Strategy

This article is part of an ongoing series in which we showcase some of the most commonly used mortgage financing strategies in California. Today, we’ll explain why some people use ARM loans to buy a starter home in California, and why it’s a strategy worth considering.

Many first-time buyers in California use adjustable-rate mortgage loans when buying their “starter home.” That’s because these loans typically offer a lower interest rate during the first few years, when compared to a standard fixed-rate loan. This results in a lower monthly payment as well.

But there are some pros and cons you should consider before using an ARM loan to buy your first home in California. So let’s explore them.

How an Adjustable-Rate Mortgage Works

As its label suggests, an adjustable-rate mortgage (ARM) loan has an interest rate that can change or adjust over time. In a typical scenario, an ARM will have a fixed interest rate for a certain period of time. After this “introductory” period, the interest rate will begin to adjust annually based on certain market conditions.

The length of the initial fixed-rate phase can vary depending on the type of loan you choose. For instance, many first-time buyers in California use the 5-year ARM loan when buying a starter home. In this scenario, the interest rate stays the same for the first five years of homeownership and then changes every one year after that.

Adjustable-rate mortgage loans are typically associated with some kind of “index.” The index is a benchmark interest rate that reflects general market conditions. The Constant Maturity Treasury (CMT) rate is one common example.

The mortgage rate assigned to an ARM loan can either adjust upward or downward, depending on the movement of the index it’s associated with. And that’s not something you can predict in advance, so there is some uncertainty here.

In California, ARM loans often start off with a lower interest rate when compared to the more popular 30-year fixed-rate mortgage. That’s what attracts some starter home buyers to this product in the first place. It gives them a way to reduce the size of their monthly mortgage payments.

We’ve just covered the two biggest pros and cons associated with adjustable-rate mortgage loans. They typically offer a lower interest rate during the first few years, but they bring some uncertainty in the picture after that initial phase.

Using an ARM Loan to Buy a Starter Home

Now that you know how an adjustable-rate mortgage loan works, let’s talk about how you might use an ARM loan when buying a starter home in California.

A starter home is a relatively affordable and often smaller house or condominium purchased by first-time buyers. It’s meant to be a stepping stone into homeownership, usually with the intention of moving to a larger or more permanent residence in the future.

California homeowners tend to stay in their starter homes for three to seven years, on average. After that, many homeowners sell their first house and purchase another.

And this is where the ARM loan comes back into the picture.

Adjustable mortgage loans can have an initial fixed-rate phase lasting anywhere from one to seven years. So a person buying their first home in California could use an ARM loan to secure a lower interest rate, and then pay the loan off a few years later when selling the property.

In this scenario, a home buyer can enjoy the upside with no downside. They can take advantage of the lower mortgage rate assigned to an ARM loan, while avoiding the long-term uncertainty that comes into the picture during the adjustment stage.

Here are the steps involved in this financing scenario:

1. Purchase your first home in California using an adjustable-rate mortgage.
2. Benefit from a lower interest rate (compared to a 30-year fixed mortgage).
3. Live in the home for a few years during the ARM loan’s initial fixed phase.
4. Sell the home before the first annual interest rate adjustment takes place.
5. Use the proceeds from your sale to pay off your mortgage balance.
6. Use any remaining proceeds to put toward your next home purchase.

This is a simplified sequence that does not cover all possible variables. For instance, there’s a chance you might have trouble selling your home prior to the first interest rate adjustment. A real estate market slowdown or economic recession might limit or delay your ability to sell the house.

With the current inventory shortage in California, homeowners usually don’t have much trouble selling their properties. Still, it’s important to consider all possible scenarios and to plan accordingly before choosing a loan option.

In Closing: A Summary of Pros and Cons

We’ve covered a lot of important information in this article. So let’s wrap things up by summarizing some of the pros and cons of this unique financing strategy.

Pros of using an ARM loan to buy a starter home:

• You could secure a lower initial interest rate compared to a fixed-rate mortgage.
• You could afford to buy a more expensive starter home.
• You could save money during the first few years of homeownership.

Cons of using an ARM loan to buy a starter home:

• The interest rate can increase after the introductory period.
• A higher rate would mean a larger monthly payment as well.
• If you stay in your home for more than a few years, you could end up paying more in interest than you would with a fixed-rate mortgage.

Overall, ARM loans can be a good option for starter home buyers in California who plan to sell the house before the interest rate adjustment takes place. Just make sure you understand the risks involved and that you have a plan in place regarding your long-term housing and financing situation.