While buyers were enjoying years of historically low rates during the pandemic, fixed rates have been soaring in recent weeks, with the average 30-year hitting 5.25% last week, according to Freddie Mac.
As a result, homebuyers are turning to adjustable-rate mortgages (ARMs) to give them an advantage as both rates and home prices continue to rise. In fact, applications for adjustable-rate mortgages have doubled over the past three months, according to the Mortgage Bankers Association (MBA).
In today’s rising-rate environment, ARMs can be appealing due to their lower initial rates, but there are some factors to consider. Here’s what you need to know about adjustable-rate mortgages, also known as variable-rate mortgages, and their pros and cons.
What is an adjustable-rate mortgage (ARM)?
As the name implies, an adjustable-rate mortgage (ARM) is a home loan with a fixed period and an adjustment period. During the initial fixed-rate period, the interest rate remains fixed. During the adjustment period, the interest rate will go up or down based on the market.
For example, a 5/1 ARM indicates that the interest rate is fixed for five years and then the interest rate will be adjusted once a year. With a 10/6 ARM, the rate is fixed for ten years and then the rate will be adjusted every six months.
A key difference between an ARM and a fixed-rate mortgage is the interest rate. An ARM typically has a lower initial interest rate than a fixed-rate mortgage, thus a lower monthly mortgage payment. After the ARM’s initial rate period, however, the rate and monthly payment can rise.
The good news is that there are caps in place that limit how much the interest rate and monthly payment can rise per year or over the loan’s lifetime.
Pros of an adjustable-rate mortgage
- Lower rates and payments in the fixed-rate period: Adjustable-rate mortgages have lower rates and monthly payments in the fixed period of the loan, thus making homeownership more affordable in today’s competitive market. For example, most buyers would prefer a 4.89% APR to 5.25%. On a $400,000 home loan, that could save over $400 a month during the initial five-year term, according to Bankrate.
- Savings and investment opportunities: With a lower rate and monthly payment, borrowers can save and invest more money. Using the example above, a borrower who has a payment that’s $400 less with an ARM can put that money in a higher-yielding investment and capitalize on their savings.
- Flexibility: ARMs provide flexibility for homebuyers who plan to move or sell their home in the next few years. Homeowners can enjoy the ARM’s fixed-rate period and sell before it ends and the less-predictable adjustment phase starts.
- Rate and payment caps: ARMs typically include several kinds of caps that control how the interest rate can adjust. The initial adjustment cap, subsequent adjustment cap, and the lifetime adjustment cap limit the possible increase in the loan’s interest rate during the adjustment period.
- Potentially lower payments in the adjustment period: If interest rates fall during the adjustment period, then the monthly mortgage payment could decrease.
Cons of an adjustable-rate mortgage
- Potentially higher payments in the adjustment period: The market is unpredictable. After the fixed period ends, rates and payments can rise significantly over the life of the loan. This can be a shock to an ARM borrower’s budget if not prepared.
- Uncertainty: Even with careful planning, borrowers may run into unexpected problems. There’s no way to predict how the housing market will be once the loan enters the adjustment period. For example, borrowers may be unable to sell their home or refinance to a fixed-rate mortgage when they want to.
- Complexity: ARMs can have complicated rules, fees, and structures. These complexities can pose risks for borrowers. Thankfully, our loan officers are here to offer their expertise and help borrowers every step of the way.
An adjustable-rate mortgage can be a smart financial choice for the right buyer. The appeal of paying a lower interest rate for the first five or seven years of a loan term can be tempting, especially to first-time homebuyers.
Some people believe fixed-rate mortgages are always the better choice. For that reason, the most common type of mortgage today is the 30-year fixed. But the typical mortgage length, or average lifespan of a mortgage, is under ten years.
“ARMs can make sense for customers who know they will be relocating in the near future or they know they will be paying off the loan in a few years,” says Don Maxon, a certified financial planner in San Rafael, California.
The bottom line
If you know you’ll be moving out of your home before the end of the adjustment period, the benefits of getting an adjustable-rate mortgage are enhanced. You can enjoy the low interest rate and payment benefits with less of the risk.
So first, ask yourself: Have you found your forever home? If not, how long do you plan on staying in the home? What’s the interest rate environment like? And most importantly, can you still afford the payments if rates jump?
If you qualify, it’s an option to take into consideration – although ultimately, it doesn’t offer the stability of a fixed-rate mortgage. Before committing to an adjustable-rate mortgage, be sure that you can afford the potential risks.
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