There’s been a surge in interest in adjustable-rate mortgages (ARMs); last year, only 4% of mortgage applications were for adjustable-rate mortgages, but that’s more than doubled to around 10% this year. We go over what an adjustable-rate mortgage is, the pros and cons, and the circumstances in which ARMs might be the right choice for you.
What is an adjustable-rate mortgage?
An adjustable-rate mortgage (ARM) offers an interest rate that goes up or down over time. They start with a fixed rate below the market rate that lasts for a certain number of years — usually three, five, or seven years. After that, the rate (and your payments) can go up, depending on the current mortgage rates.
Pros & cons of adjustable-rate mortgages (ARMs)
That initial low rate could offer significant savings. As of June 2022, the average starting rate on ARMs was a full percentage point lower than on conventional loans, 4.04% vs. 5.09%. That’s s difference of more than a 20% in mortgage costs!
However, adjustable-rate mortgages got a bad reputation after the 2008 crash when huge, overnight increases in some ARMs led to foreclosures. But ARMs have been reformed since then, and have more reasonable, transparent terms, making them a safer choice for homebuyers.
Benefits of an adjustable-rate mortgage
Most ARMs now have limits on how much your rate or your payment can increase at one time, as well as limits on how much the rate can increase throughout the mortgage. These caps protect you from the sudden, astronomical increases that led to foreclosures in the wake of the 2008 financial crash when many ARMs were essentially open-ended.
Low upfront payment
Because you get such a low rate in the initial low rate period, your payments during this time will be extremely affordable compared to a conventional mortgage. And because this rate’s locked in for a specific period, you can plan around it in the long term.
The ARM works well if your lifestyle is in flux. Say you’re in the early stages of your career and you can reasonably anticipate a big income bump in the next few years. In this instance, an ARM might be perfect for you. It’s affordable in the short term, and then when the rate increases, your income will be able to accommodate the larger payments.
Your payments won’t necessarily go up, they could decrease
Many people fixate on the risks of the ARM and assume your rate (and payments) will go up. However, if interest rates fall, your ARM would follow suit, granting you lower payments. While this isn’t all that likely today, with interest rates heading up to combat inflation, it’s always a possibility!
Potential drawbacks of an adjustable-rate mortgage
Your payments could go up
If interest rates go up during your fixed-rate period, your payments will increase when you enter your adjustable-rate period. If you’re looking at an ARM in 2022, this will likely be the case, since the Federal Reserve has been open about raising interest rates to combat inflation.
They are complicated
Like most financial products, ARMs have complex terms. Figuring out what can trigger a higher rate, and how much your rate will increase is a lot more complicated than calculating other costs associated with buying a home.
If you’re considering an ARM, do your research by getting expert opinions and talking in detail to your lender. If you fail to read and understand the fine print, you might find yourself paying a lot more than you bargained for, a lot sooner than you bargained for. Always read the fine print, and ask your lender for clarification where it’s needed!
The market fluctuates
Many people who opt for ARMs plan to pay the lower rate during the initial period, and then sell before the rate goes up. The problem is that demand in their market could dry up, and they might find it very difficult to offload the property before their higher payments kick in. In times of market fluctuation, it can be hard just to accurately estimate property value, so sales are tough. Remember, there’s always some risk inherent in investing!
Is an adjustable-rate mortgage right for you?
Buying a house is getting more expensive. Year-over-year, home prices have surged over 20% according to Zillow, and interest rates on 30-year fixed-rate mortgages are now over 5%, up from below 3% a year ago. This has left home buyers scrambling for ways to save money.
Some have turned to getting a home buyer rebate or working with a discount realtor to put some money back in their pocket. Others have looked to save on their mortgage. While there are pros and cons of adjustable rate mortgages, they can be a great choice for certain homebuyers.
If you’re planning on moving in the next few years…
An ARM will get you a lower-than-market-rate mortgage in the short term and you’ll be gone before the higher rate ever kicks in. This could save you thousands of dollars throughout just, say, five years. You’ll have to run the to see if the initial savings are worth it to you.
If you’re planning to refinance later on
An ARM is also great if you know you can refinance before higher rates kick in. When you get close to the end of your low rate term, you can refinance into a conventional fixed-rate mortgage, or another ARM, essentially restarting the clock on your low rate term. This used to be dicey since many ARMs had prepayment penalties if you refinanced before a certain time, but those were eliminated in the post-2008 ARM reforms.
If your income is poised to increase
Finally, another situation that’s perfect for an ARM is if you know your income will go up in the future — for example, if you or your partner is enrolled in a professional degree that will secure a lucrative job in a few years. An ARM will get you in the door with low mortgage payments, and if those payments go up in the future, you’ll have more income to make those higher payments.
Article last modified on September 23, 2022. Published by Debt.com, LLC