Time to Start Thinking About Adjustable-Rate Mortgages Again?
Does an adjustable-rate mortgage, better known as an ARM, look more attractive to you today? You're not alone. The low mortgage rates that come with an ARM loan today are making these alternate mortgage products seem more attractive to a growing number of borrowers.
Be careful, though. ARMs do come with some uncertainty. And they're not the right choice for every home buyer.
Before deciding on an adjustable-rate mortgage over the more traditional fixed-rate loan, it's important to understand how ARMs work and how much uncertainty comes with them.
How an ARM works
Adjustable mortgage rates are usually lower than are the rates attached to traditional fixed-rate mortgages. That lower rate, though, only remains in place during a set number of years, usually five to seven. After that fixed period ends, the interest rate adjusts according to whatever financial indices the interest rate is tied to.
You won't know, then, what your interest rate will be after the fixed period ends. Your rate could rise higher once it adjusts. This isn’t certain, though. Rates can fall, too. You just won't know when you take out your loan in which direction rates will go.
This means that if you take out an adjustable-rate mortgage, you need to be ready for some uncertainty. And you need to be able to handle a higher monthly payment that will come if your rate adjusts upward.
Lower interest rates
Adjustable-rate loans are becoming more popular today largely because the interest rates on standard fixed-rate mortgages are on the rise. Consumers are turning to adjustable-rate loans as a way to avoid those higher rates. Ralph DiBugnara, vice president of retail sales with White Plains, New York-based Residential Home Funding, said that he has seen a steady increase in the number of borrowers interested in an ARM loan.
Consider these numbers: Freddie Mac reported that as of Feb. 22, the average interest rate on a 30-year, fixed-rate mortgage stood at 4.40 percent. The average interest rate on a 5/1 ARM, though, was a lower 3.65 percent. That rate was lower, too, than Freddie Mac's reported average rate of 3.85 percent for 15-year fixed-rate mortgages.
It’s not surprising, then, that mortgage lenders are seeing more requests for ARM loans. Those lower rates mean that homeowners can enjoy a smaller monthly payment, at least until their rate eventually adjusts.
Look at your goals first
However, just because ARM rates are low initially, doesn't mean that an adjustable-rate mortgage is right for every borrower today. It all depends on the borrowers' goals, DiBugnara said.
ARM loans make the most sense for borrowers who don't plan on living in a home for more than five or seven years. These borrowers can then get out of the house and into their next one before their interest rates adjust.
"You need to have a short-term plan," DiBugnara said. "Maybe you're buying a starter home and you'll be out in five to seven years. If that's the case, an ARM is a great option."
But if you plan on staying in a home for a longer period of time? Then an ARM might not be the best choice, DiBugnara said.
"If you are undetermined about how long you are going to stay in the house, then a fixed-rate mortgage makes the most sense," DiBugnara said. "We don't know what interest rates are going to be in five years. Rates are still low enough today to lock into a fixed-rate mortgage and be happy. Unless you are going to be out of your house quickly. Then you should lock in the cheaper money with an ARM."
The different types of ARM loans
If you are interested in the initial interest savings that come with an adjustable-rate mortgage, you will have to do some research. These loans come in several different types. The key, though, is to look at the two numbers that come with your ARM loan. The first number in an ARM's name describes the number of years that the initial interest rate remains locked in. The second number explains how often the interest rate will adjust following that initial fixed period.
For instance, with a 5/1 ARM, your initial interest rate will remain in place for five years. Your rate will then adjust every year. With a 5/5 ARM, your initial interest rate will remain fixed for five years and then adjust once every five years. With a 7/1 ARM, your rate is locked for seven years before adjusting every other year after.
There are some protections for consumers. ARMs typically come with caps that will regulate how much a rate will adjust. There might be an initial cap stating that the first time the rate adjusts it can’t adjust higher than 1 or 2 percentage points. Your loan might also come with a cap on subsequent interest rate adjustments. It might say that your rate can’t rise by more than 2 percent when it adjusts in the future, whether those adjustments come every year or every five years.
Finally, your loan might also feature a lifetime cap. This states the maximum that your loan can adjust over its lifetime. Often, this cap will be set at 5 percent, meaning that your interest rate can never rise more than 5 percent from its starting point.
Not all real estate professionals have the same view on ARM loans. Some consider them ways to save on mortgage costs. Others say they are too risky.
Bruce Albion, a real estate agent with RE/MAX Town and Country in Atlanta, said that adjustable-rate loans make more sense for more borrowers today because so many homeowners move long before they pay off longer-term mortgages. How many homeowners who take out 30-year, fixed-rate loans stay in their homes for the full three decades and pay off their mortgages in full?
Not many, Albion says. And for such borrowers, taking out long-term loans doesn't make as much financial sense as does applying for an ARM, he said.
"Taking out a 30-year mortgage is essentially buying the use of that money for 30 years when more than half will have moved before 15 years are up," Albion said. "If you are that homeowner, you will have paid a premium to have access to money at a fixed rate. It's like buying enough frozen chicken to last 30 years when it will go bad after 15 years. Why do that?"
Albion recommends that the fixed period of any ARM that you take out matches or exceeds the number of years you expect to live in your home. If you plan on living in your home for five years, consider 5/1 ARM, 5/5 ARM or, to build in more of a cushion, a 7/1 or a 7/5 ARM.
Corey Chappell, closing options analyst with 181-Close-Now, a home-selling service in Oklahoma City, Oklahoma, though, isn't sold on the benefits of an ARM loan. He said that too many people don't understand how ARMs work, and too many others use them as a way to live beyond their financial means.
Chappell said that when people take out ARM loans, they understand that their interest rate might jump 1 percent or 2 percent after the fixed period ends. What they don't understand is the impact that seemingly small increase will have on their mortgage.
Chappell said that buyers, too, often use ARMs to get into homes they can't really afford. That initial low interest rate leaves them with a monthly payment that is at the top of their budget range. When the rate adjusts, their payment rises to a level that they can no longer afford.
"Adjustable-rate mortgages can be an amazing financial tool for a very small group of people like investors or people who plan to sell a property well in advance of a rate hike," Chappell said. "But for the majority of consumers looking to purchase a home, they are financial suicide."
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