With rates rising, is an ARM in your future?
It took a hotly contested national election, but the average interest rate on a 30-year, fixed-rate mortgage finally soared over 4 percent shortly after Donald Trump's surprise presidential victory. And rates on these mortgage types have stayed put at that level ever since.
Which leads to the big question: Is this the right time to consider an adjustable-rate mortgage (ARM) as an alternative to a fixed-rate product?
As their name suggests, the mortgage rates attached to adjustable-rate mortgages change -- or adjust -- during the life of a loan. The benefit is that initial adjustable mortgage rates are lower, often by a half percent or more, than those attached to 30-year or 15-year fixed-rate mortgages.
These lower rates do adjust, though, usually after five to seven years. When they do, they almost certainly move higher than those borrowers nab during the initial fixed period. They might move higher than the rate you'd be able to secure today with a 15-year or 30-year fixed-rate mortgage.
A tough question
The question, then, is a complicated one: Are those five to seven years of interest-rate savings worth the risk that your rate after it adjusts might be higher, maybe much higher, than what you could fix in place today for 15 or 30 years
Janis Bronstein, vice president with the Hampton, New York, office of FM Home Loans, says that the answer usually depends on how long you plan on remaining in the home you are buying.
"The first question I ask is how long people see themselves staying in a home," Bronstein said. "Adjustable-rate mortgages can be a good option for people who are buying houses in the short term, who think they'll be moving on in five or seven years. They can then sell and move on before their loan even adjusts in many cases.”
There's a second question, too: Bronstein always asks borrowers about their priorities. Is nabbing the lowest monthly mortgage payment the most important goal? Or are borrowers more interested in the stability that comes with a fixed-rate loan.
"Maybe you know you'll be getting a promotion and an income increase soon. To get into a home now before that happens, you need the lower payment that comes with an adjustable-rate mortgage," Bronstein said.
"Things might be tight financially now, but in a year or two your financial situation will improve. With the lower monthly payment that comes with an adjustable-rate loan, you can maybe get into that house that you couldn't afford with a standard fixed-rate loan."
There is a risk with this approach, of course. You might not get that promotion and pay raise, no matter how certain you are that it’s coming. Make sure that you can afford the increased mortgage payment that might result when your loan’s rate adjusts.
How they work
Adjustable-rate loans are broken into two stages, the fixed stage and the adjustable stage. Your interest rate will usually remain fixed for five, seven or 10 years, depending on the type of adjustable-rate loan you take out. After this initial period, your rate will adjust, according to whatever financial index your loan is tied to. Usually, though, you can count on your interest rate rising after the fixed period ends.
The type of adjustable-rate loan you take out tells you how often your interest rate will adjust following the fixed period. A 7/1 adjustable-rate loan, for instance, comes with an initial interest rate that remains fixed for seven years. It then adjusts every year after the initial period ends.
A 5/5 adjustable-rate mortgage comes with a fixed rate for five years. The rate then adjusts every five years after the fixed period ends.
Lower rates are lure
The allure of adjustable-rate loans? Their lower initial interest rates.
Consider the Freddie Mac Primary Mortgage Market Survey for December 1. Freddie Mac reported that the average interest rate attached to a 30-year fixed-rate mortgage stood at 4.08 percent, while a 15-year fixed-rate loan came with an average interest rate of 3.25 percent.
The average rate for a five-year adjustable-rate mortgage, though, was 3.15 percent, according to Freddie Mac, significantly lower than with the 30-year loan and slightly lower than what you could expect with a 15-year mortgage.
Mark Kahn, director of sales with Brooklyn-based FM Home Loans, said that he expects demand for adjustable-rate loans to only increase as interest rates remain over 4 percent on the 30-year, fixed-rate loan.
Part of the reason? Many consumers became spoiled with so many months of rates below 4 percent. That 4 percent mark has become a psychological barrier for many consumers. They are now turning to adjustable-rate loans because they think that any interest rate over 4 percent is a high one, ignoring the fact that just 10 years ago rates under 7 percent on 30-year loans were considered outstanding.
There are other borrowers, though, who will turn to adjustable-rate loans out of necessity, Kahn said. They won’t be able to qualify for their mortgages now that rates on traditional 30-year loans have crept past 4 percent.
That’s because these higher rates will throw off their debt-to-income ratios. Lenders want borrowers’ total monthly debts, including their new monthly mortgage payment, to equal no more than 43 percent of their gross monthly income. A higher interest rate might push borrowers’ monthly mortgage payment up just high enough to break that 43 percent limit, Kahn said.
“The only way these borrowers can now do the loan is to take out an adjustable-rate mortgage with a lower interest rate,” Kahn said. “They have no other choice.”
Is an adjustable-rate loan the right choice for you?
So, is an adjustable-rate mortgage the right choice for you? That depends, largely, again, on how long you plan on living in a home.
Casey Fleming, author of The Loan Guide: How to Get the Best Possible Mortgage and mortgage advisor with the San Jose office of C2 Financial Corporation, said that while adjustable-rate mortgages are more unpredictable than fixed-rate loans, the financial hits during the adjustment period are often minor ones, especially for those borrowers who do plan on holding onto their real estate for shorter periods of time.
Even assuming the worst-case scenario in which interest rates rise as far and as fast as possible, borrowers with an adjustable-rate mortgage can hold their adjustable loans for two years after the interest rates adjust without paying more interest to their lenders than they would have had they taken out a 30-year, fixed-rate loan, Fleming said.
In other words, if you take out a five-year adjustable-rate mortgage, you'll usually be ahead financially even after the seventh year of your loan begins, Fleming said.
"If you think you have a short holding period and you have the stomach for some risk, you can save a lot of money using an adjustable-rate mortgage," Fleming said.
Kahn said that borrowers need to understand the risks associated with adjustable-rate mortgages. The odds are that mortgage interest rates won’t be lower in five, seven or 10 years than where they are today, Kahn said. So when your rate does adjust, you’ll need to be ready for your mortgage payment to increase.
“I’m not an economist, but it seems to me that we will continuously see increasing mortgage interest rates,” Kahn said. “That seems to be where we are headed.”
Kahn said that if you plan on raising your family in one home that you stay in for decades, a fixed-rate loan is the smart choice. If you plan on living in a home for seven years or less? That’s when an adjustable-rate mortgage might make sense, Kahn said.
“But when you do plan on staying for a long time? I always advise borrowers to go with the fixed-rate loan,” Kahn said. “That holds even if the monthly payment will be higher during that first fixed period. There’s just so much uncertainty with the adjustment period.”