As interest rates rise for conventional loans, home buyers are turning to adjustable rate mortgages in increasing numbers. According to the Mortgage Bankers Association, ARMs accounted for 10.8% of all mortgage applications at the beginning of May, up from 3.1% at the beginning of the year.
Home loans with variable interest rates offer savings and lower monthly payments at the beginning of the loan, and help borrowers reduce the initial squeeze of higher rates and high home prices. But ARMs come with some added risks, and it’s important to understand how they differ from conventional loans before you decide if one is right for you.
Why adjustable rate mortgages are heating up
“ARMs are popular right now because fixed-rate mortgage rates jumped,” says Dan Green, president of Cincinnati-based mortgage company Homebuyer.com, a mortgage lender for first-time homebuyers. The popularity of ARMs directly correlates with fixed-rate mortgage rates — the higher the rate, the more popular ARMs tend to get, he says.
As of June 2, the average interest rate for a 30-year, fixed rate mortgage is 5.09%,  while the average rate for a 5/1 adjustable rate mortgage (we’ll explain what that fraction means in a second) is 4.04%.  Lower interest rates equal lower monthly payments, and borrowers with a 5/1 adjustable rate mortgage can save $15,000 over the first five years of the loan.  These savings are the primary advantage of ARMs over conventional loans.
How ARMs work
The most common type of adjustable mortgage is a hybrid adjustable rate mortgage, which offers a lower fixed interest rate for a set amount of time (typically three to five years). After that, the interest rate periodically readjusts on a recurring basis at the adjustment period. Of these loans, the most common is the 5/1 ARM, which has an initial fixed-rate period for five years then readjusts annually until the loan is paid off.
The loan readjusts based on a predetermined benchmark known as the index, which may be the prime rate, the Cost of Funds Index (COFI), or something else. Then the lender adds a set number of percentage points, known as the margin, on top of that benchmark to arrive at your new rate.
For example, if your adjustment period occurs when the index rate is at 4% and your margin is 2%, your new rate will be set at 6%. Your rate and monthly payment could increase or decrease as a result of this adjustment, depending on if the index has increased or decreased since the last time it was adjusted.
There may be limits to how much your loan can be adjusted. A lifetime interest rate cap limits how much your rate can increase from the initial interest rate — so an adjustable rate mortgage with a 5% lifetime cap can never increase more than five percentage points on top of the rate you originally agreed to. Some adjustable rate mortgages have periodic adjustment caps that limit how much the rate can adjust up or down from one period to the next (although they may make an exception for the first adjustment period of the loan), and some have payment caps that limit how much your payment can increase from one period to the next.
In summary, your monthly payment will be fixed at a lower amount than you’d pay with a fixed-rate loan, but only for the initial period. After that, your rate will periodically adjust, and it could increase or decrease based on the index the loan tracks.
How current ARMs are different from pre-2008 ARMs
Leading up to the 2008 housing crisis, lenders used adjustable rate mortgages with extremely low introductory interest rates to attract home buyers. They often extended loans to subprime borrowers and failed to verify that the borrower had the means to repay the loan. When the rates adjusted, borrowers found themselves unable to afford their monthly payments.
Regulations put in place since the housing market crash require lenders to verify borrowers’ repayment ability. And predatory loans with extremely short initial repayment periods, below-market teaser rates, or payments that only cover interest have been restricted or eliminated entirely.
To put it simply, “fewer applicants qualify and subprime ARMs no longer exist,” Green said. This helps borrowers avoid getting in over their heads with predatory loans or loans they just can’t afford.
When it makes sense to use an ARM loan to buy a home
Adjustable rate mortgages have distinct advantages. You can lock in a low introductory interest rate, lowering your monthly payment and saving you money for the early years of the loan. Loans can use lifetime caps, periodic adjustment caps, and payment caps to help you avoid excessive rate hikes. And if the index falls, you could actually see your payment decrease.
But ARMs still come with inherent risk. If the index rises at the adjustment period, your monthly payments could increase and tighten your budget, or even cause you to have trouble making your payment. And if the housing market slumps and your home’s value falls, you could have trouble refinancing or selling your home if you still owe more than your home is worth.
ARMs make the most sense if you plan to sell or refinance your home within the initial fixed-rate period, as you can take advantage of the lower interest rate and get out before it adjusts. They’re more risky if you plan to be in your home for the long run, especially if you’re not prepared for the possibility of higher payments.
“ARMs are sensible when a buyer knows they'll refinance or sell and move out within [the initial rate period],” says Green, “or when a buyer doesn’t mind sharing in the time-risk of an adjusting loan. ARMs should not be used as an affordability tool or when the thought of using an ARM makes a buyer uncomfortable.”
One wrinkle to consider is that some adjustable rate mortgages come with a prepayment penalty, which could be thousands of dollars, and is charged if you sell or refinance your loan within the initial rate period. This could eat into the savings you’d get from purchasing a home with an adjustable rate mortgage and getting out before the adjustment period hits. Make sure you check for prepayment penalties with any lender you’re evaluating.
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