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When is an adjustable-rate mortgage a good idea?

January 4, 2023, 3:16 PM UTC
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ARMs make home ownership more affordable—at least initially.
Photo illustration by Fortune; Original photo by Getty Images

Throughout 2022, mortgage interest rates steadily ticked upward in a march that priced many prospective homebuyers out of the market. The interest rate on a 30-year fixed-rate mortgage began last year at around 3.26%, and by the time December arrived, rates had reached a steep 6.47%.

With home ownership being such a pricey proposition, more than a few buyers may need to find alternative ways to get into a property. In this environment, adjustable-rate mortgages (ARMs), which offer a lower introductory interest rate than traditional fixed-rate mortgages, may be an appealing option.

But there are pros and cons to keep in mind when considering ARMs, including the fact that the interest rate doesn’t remain low forever, and when it finally adjusts, your monthly payments may increase and even become prohibitively expensive.  

What is an adjustable-rate mortgage, and how does it work? 

An adjustable-rate mortgage begins with an initial introductory interest rate and after the promotional period ends, the rate adjusts either on a monthly or yearly basis in tandem with market fluctuations. The introductory rate may last for as little as six months or as long as 10 years, and it is often far lower than rates available on 30-year fixed-rate mortgage loans.

“An adjustable-rate mortgage is a mortgage product based on a 30-year repayment schedule, but the interest rate is not permanently fixed for the entire 30 years,” says Brian McCauley, a mortgage officer with Fairway Independent Mortgage Corporation—The McCauley Team, a Texas-based lending team. “The most common ARM options are a five-, seven-, and 10-year ARMs… The shorter the time frame you choose, the lower and more competitive the interest rate, so you want to choose wisely to maximize as much savings as you can without putting yourself at high risk.”

There are also various caps in place regarding how much ARM interest rates and the resulting monthly mortgage payments can increase, according to the Consumer Financial Protection Bureau (CFPB). The caps cover the initial rate hike once the introductory period ends, as well as subsequent rate adjustments, and adjustments over the lifetime of the loan.

The initial rate increase after the intro period ends is typically between 2% to 5%, according to the CFPB. Subsequent rate adjustments, meanwhile, are often around 2%. And over the life of the loan, the rate generally shouldn’t increase more than 5% higher than your initial rate.

Pros of adjustable rate

While there are some risks involved, there are also many benefits when using ARMs, particularly for short-term home buyers who may move before the interest rate resets, those planning to refinance their mortgage down the road, and for buyers with a strong and consistently reliable cash flow. 

Low initial interest rates

For first-time home buyers who are finding fixed-interest rate mortgages prohibitive amid the current environment, ARMs offer a valuable way to make home ownership more affordable.  As of January, ARM rates are between 5.5% and 6.16%, according to Bankrate, while the rates on 30-year fixed mortgages start around 6.6%.

“In this high-interest rate environment, ARMs can be a way to start homeownership at a lower interest rate with the hope of refinancing if interest rates come down prior to when the five-, seven- or 10-year initial fixed period ends,” says Jack Kammer, vice president of mortgage lending for the national mortgage originator OriginPoint.

You can put more toward principal

Because the monthly mortgage payment starts out so much lower with an ARM, home buyers may have the opportunity to direct some of that saved money toward paying down the loan principal more aggressively.

“If you’ve decided on a specific monthly house payment budget, an ARM could allow you to apply the difference between the mortgage payment and the higher budgeted payment,” Kammer adds. 

In addition to using that saved money to diminish principal, you can also use the free cash toward other worthwhile investments and even paying down debt.

Payments decrease when interest rates fall

Though interest rates have been trending upward for a year now, when rates decrease, so too does the interest on your ARM, and as a result, your monthly mortgage payment as well. In other words, the adjustable element of an ARM doesn’t mean the rate always goes up, though ARMs have earned a reputation for primarily doing just that. 

“The starting rates can go down with the market as well once that temporary period expires.  I’ve seen clients benefit from this many times,” says McCauley. “There are substantial savings for the client—cheaper payments, more affordability, and more money in their pocket to save, invest, or even use to pay off other debt. It creates more cash flow and accelerates a client’s wealth accumulation.”

Cons of adjustable rate

Despite the many benefits already identified by experts, ARMs may not be the right choice for all homebuyers. The unpredictability of regularly adjusting payments and slightly complex rules associated with these mortgages may be off-putting for some buyers. This type of mortgage may also be a bad choice for those who are unsure how long they may remain in a home.

Higher payments when interest rates increase

Though this point has already been emphasized by experts, it’s an important one to understand: Payments on an ARM can trend upward enough that it may make the expense untenable for some people’s budgets, particularly if their income has been impacted in any way at the same time.

“If you don’t do anything with the ARM once the initial short-term fixed rate expires and the market is up at that time, your adjustable rate will continue to increase with the market over time,” says McCauley. “There are rules around these adjustments—so it won’t go from 3% to 7% overnight, but it can steadily rise each year, so this can get costly in the monthly payments if you don’t take action quickly.”

Once the introductory period ends, you need to be financially ready to refinance, move, or have the means to cover the new, higher mortgage payment. If you opt for refinancing, it’s important to remember that doing so in a high-rate environment may not be ideal either.

“Refinances aren’t necessarily bad as long as there is a strong net tangible benefit to the borrower,” explains McCauley. “Refinances also have closing fees, and they are fully qualifying home loans which means you have to do an all-new credit report, updated financials, and a new appraisal. So, you need to ensure you qualify and are prepared for this refinance if this ends up being the route you choose.”

Complicated rules and fees

By their very fluctuating nature, ARMs are more complicated than a simple fixed-rate mortgage. You’ll need to stay abreast of when the introductory rate ends, as well as other rules and fees associated with an ARM. This can be more challenging for new home buyers or those who don’t take the time to fully review the nuances of how an ARM works.

“The disclosure process also has one extra disclosure with the purpose of fully explaining and educating the borrower about an ARM,” says Kammer. “This is called the Consumer Handbook on Adjustable-Rate Mortgages.”

You may struggle to make payments when intro period ends

As the past few years have made abundantly clear, it’s hard to predict the future, and your financial situation could be vastly different when the introductory period for your ARM ends. For this reason, ARMs should be considered carefully.

“The danger of an ARM is the delayed risk that’s not apparent during the introduction period,” says Mike Hardy, managing partner for national lender Churchill Mortgage. “As we’ve seen firsthand recently, markets can behave irrationally when we least expect it. If an ARM reset takes place during an unfavorable economic cycle, that can potentially lead to a higher-than-affordable payment after an ARM reset.”

The Great Recession of 2007 and 2008 offers a vivid example of this potential scenario and downfall. Many of the attractive ARM loan programs from 2004 through 2006 were designed to reset after two or three years. As inflation set in a few years later and the Federal Reserve tightened the Federal Funds rate in response, many ARM products reset and caught scores of homeowners by surprise, which ultimately caused a great deal of financial challenges and hardship.

“I’d only recommend ARMs for more sophisticated investors or highly disciplined individuals who have not only a short-term need in housing but also the financial wherewithal to weather economic surprises and swings in the market,” says Hardy.

When is an adjustable rate mortgage right for you? 

So how to decide when an ARM is right for you? There are a variety of considerations to sort through as you figure out what’s best for you and your financial needs. Perhaps the first and most important question to ask is how long you plan to be in the home.

“While a risky bet for those with a long-term outlook, an ARM can make sense during shorter-term housing needs,” says Hardy. “In some cases, an individual or family will have a five-year window and know this upfront. In this scenario, a five- or seven-year year ARM makes sense, as the higher the level of certainty in a timeline, the better for planning to go in this direction.”

Using an ARM may also make sense if you’re looking for a starter home and may not be able to afford a fixed-rate mortgage. Historically, says McCauley, most first- and second-time homebuyers only stay in a home an average of five years, so ARMs are often a safe bet.

When should you avoid an adjustable-rate mortgage?

For some homebuyers, an ARM will simply not be a sound financial choice. This is particularly true for those who are already having challenges obtaining a mortgage of any kind or are stretching their finances to make mortgage payments work within their operating budget.

“An ARM should be avoided if you are right on the edge of qualifying, as I lean toward the elimination of as much risk as possible,” says Hardy. “A fixed-rate mortgage, however, is similar to buying insurance against a worst-case scenario—not all that unlike health or car insurance.”

ARMs are also not the best choice for those who prefer the certainty of a reliable payment or for buyers whose finances fluctuate and therefore need long-term predictability in their monthly mortgage. 

The takeaway 

Amid the current high-interest-rate environment, an ARM can offer a more affordable mortgage payment. But the introductory interest rate that makes your monthly payments cheaper won’t last forever. Be sure to consider your financial picture over both the short term and long term and ensure that you can comfortably afford a mortgage payment once the rate begins fluctuating. 

“ARMs are really good products that help people get a lower rate, save more money, and feel better about affordability,” says McCauley. “The homebuyer just needs to fully understand all of their options, get with an experienced mortgage adviser, set up an entire mortgage planning session, and go through every loan and financial option available for them. Becoming a homeowner is one thing. Becoming a smart homeowner is another, and that’s the ultimate goal.”

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