Adjustable-rate mortgages are becoming more popular as rates soar. Here’s when it makes sense to opt for one
As interest rates on traditional fixed-rate 30-year mortgages climb higher and higher, an increasing number of buyers are turning to adjustable-rate mortgages in hopes of getting a better deal.
But while the potentially lower rates these mortgages can offer may seem appealing at first glance, buyers need to take the time to do the calculations to make sure it's a smart decision for the long term.
A traditional mortgage locks in an interest rate for 15 to 30 years, depending on the loan. While buyers were enjoying years of historically-low rates during the COVID-19 pandemic, fixed rates have been soaring in recent weeks, with the average 30-year hitting 5.25% last week, according to Freddie Mac. At the start of the year, the average was around 3.4%.
Couple that with the highest prices and lowest inventory on record, and home ownership becomes a lot less attainable for many people. As everything gets more expensive, people begin to hunt around for a deal.
That's where adjustable-rate mortgages—or ARMs—come in. Buyers can sometimes get lower interest rates for the first term of their mortgage, typically five, seven, or 10 years. Currently, the national average 5/1 ARM APR is 4.89% and the average 10/1 ARM APR is 4.65%, according to Bankrate. The interest rate a buyer is offered will depend on a host of personal factors, including their credit score and income.
An ARM can make home-buying more affordable at the beginning of the loan term. For example, a 5/1 ARM can have an interest rate of 4.89% for the first five years. Once the first five years of the loan term elapse, the rate may go up—or it might also go down. This continues every five years until the loan is paid off or the buyer refinances.
The appeal of paying a lower interest rate for the first five or seven years of a loan term can be appealing, especially first-time buyers. And it can be a good deal: 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.
But ARMs can also backfire, says Greg McBride, chief financial analyst for Bankrate. If the interest rate shoots up at the end of the initial term, the buyer may be on the hook for an unaffordable payment.
"That's a calculated risk," says McBride. "Can the buyer absorb higher payments?"
McBride cautions this is especially dangerous for those who can only afford a small down payment. They may not have enough equity in their home to refinance at a better rate when their interest rate adjusts, leaving them in a bind.
That said, taking out an ARM could make sense for someone who doesn't plan to stay in their home long-term, says McBride. If you're buying a starter home, for instance, and plan to look for something else in a few years, you can lock in a lower rate, set aside or invest the money you're saving over the years, and then sell at the end of the initial term.
Of course, there's no guarantee this plan will play out cleanly. Future economic conditions—both the broader market's and your own finances—are impossible to predict.
"We’re stringing together a lot of contingencies here. A lot of people won't save the difference," says McBride. "Through no fault of the borrower, life happens."
Mortgage lenders typically present alternative financing options to buyers, which include ARMs. If you qualify, it's an option to take into consideration—although ultimately it doesn't offer the stability of a fixed-rate. And if you can't actually afford the mortgage payments you would pay with a 30-year mortgage right now, it's probably best to wait until your finances improve.
"If you’re looking at an adjustable rate as a crutch for affordability, that's a huge red flag," says McBride. "A 30-year fixed rate mortgage may not always be the optimal loan, but it’s your best gauge of affordability."
This story was originally featured on Fortune.com
