More buyers are turning to adjustable rate mortgages as interest rates on fixed rate loans rise. The potential short-term savings are huge, but so are the potential downsides.
As of May 20, ARMs accounted for more than 9% of all mortgage applications, according to the Mortgage Bankers Association. At the start of the year, ARMs accounted for just 3.1% of loan applications, which is more typical.
The ARM rush comes as the average interest rate on the wildly popular 30-year fixed-rate loan rose above 5%. Meanwhile, the average rate of the most common variable-rate loan – an ARM 5/1 – rose at a much slower pace to around 4%.
At roughly current mortgage rates, borrowers opting for a 5/1 variable rate mortgage on a median-priced home could save more than $15,000 in the first five years of the loan compared to a 30-year fixed rate, according to real estate brokerage Redfin. It’s about $260 per month.
“People are looking for other ways to expand affordability and an ARM, in certain circumstances, provides that flexibility for some borrowers,” says Brian Rugg, credit manager for mortgage lender loanDepot.
In particular, Rugg points out that buyers who have been looking for a home for a while but haven’t been able to find one could counter the loss of affordability and expand their buying power by turning to an adjustable-rate loan.
How MRAs work – then and now
For the first few years of an adjustable rate loan – usually 5, 7 or 10 years – the loan will actually have a fixed rate. After the introductory period ends, the rate will become adjustable and change at regular intervals – often annually or every six months – for the remainder of the term of the loan, which typically lasts 30 years in total.
In the early 2000s, many homebuyers were lured into ARMs by extremely low teaser rates. However, lenders did not cap how much the interest rate could rise once it became adjustable. When those introductory rates expired, monthly payments rose beyond what many homeowners could afford, triggering a wave of foreclosures and sending the housing market into a tailspin. Combined with lax lending practices, this was one of the factors that caused the housing market crash of 2008.
Since then, lending standards have become much stricter and regulations now limit the maximum amount of interest that can be charged on an adjustable rate loan. In addition to your starting rate, make sure you know your loan limits. These include:
- The annual cap is often around a maximum of 2 percentage points above the previous rate, but can be higher on the very first rate change.
- The maximum or lifetime loan cap is usually 5 percentage points above the initial rate, although some lenders have higher caps.
If you take out a 5/1 ARM at today’s average rate, that would mean your rate could be as high as 9%. (Use an ARM calculator to determine your maximum monthly payment.) Your rate may increase or decrease several times over the term of the loan, although increases are more common.
“When considering an ARM, ask yourself if the loan will be affordable and sustainable in a fluctuating rate environment,” advises Rugg.
The advantages and disadvantages of an ARM
Just because an ARM has a lower rate doesn’t mean it’s the right choice for you. It will depend on your financial goals, Rugg notes, because “every situation is unique.” Consider both the pros and cons of adjustable rate loans to see if they fit your goals.
Lock in a lower interest rate
The average initial interest rate on an ARM is currently more than 1 percentage point lower than the rate on a 30-year fixed rate mortgage. Choosing an ARM means you can lock in that lower rate for a set number of years, saving money on your monthly payments and lowering your borrowing costs.
For example, you want a mortgage of $300,000. With a 30-year fixed rate mortgage at an interest rate of 5.30%, your monthly payments would be approximately $1,666. With an ARM 5/1 at 4.08%, your monthly payment would be $1,446, but only for the first five years of the loan.
Flexible fixed rate terms
If you know you’ll only be staying in the house for a few years, an ARM might be a good option. You can lock in a low interest rate, which will make monthly payments more affordable and reduce your total borrowing costs.
The key, however, is to sell before the end of the fixed rate phase of the loan. If your future plans include moving to another city in the next 5-6 years, an ARM 7/1 or 10/1 will cover that time frame and even provide some breathing room.
You can refinance the loan
You can monitor mortgage rate trends for signs of increases once the variable rate phase of the ARM begins. If the rate starts to climb, you have the option of refinancing a lower rate loan to ensure your mortgage payments stay within your budget.
Interest rate and monthly payments may increase
Taking an ARM is a bet on what mortgage rates will do in the future. Although there is always a chance that they will decrease during the variable rate period of your loan, the more likely scenario is that they will increase, which will increase your monthly payment.
“The worst case scenario is that a borrower stays in a property beyond the fixed rate term and is now at the mercy of the market as to what the newly adjusted rate would be,” says Pat Sheehy, CEO of the mortgage lender. Hamilton Home Loans.
There may be prepayment penalties
Some lenders charge a prepayment fee if you pay off the loan before the end of the term, either through a sale, additional payments, or refinancing into another loan. These fees can increase the cost of refinancing in particular and should be taken into consideration before deciding on a refinance. Ask your lender about the prepayment penalties before you sign the loan and make sure you know the fees. Better yet, try to choose a lender with no prepayment penalties.
You may not be able to sell or refinance
Your financial situation or the housing market may change after you purchase an ARM. You may not be able to sell the house in the expected time frame or you may not qualify for a lower rate loan. Either way, you could be locked into a loan with higher payments than you can afford, which could eventually lead to foreclosure.
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