Adjustable-rate mortgages are often overlooked by home buyers, but thanks to high interest rates and shifting economic environments, experts say these lesser-used loans could be an attractive option for some borrowers.
As the name suggests, adjustable-rate mortgages are a type of loan where the interest rate changes over time. When benchmark rates rise, so do the interest rates on adjustable-rate, or variable, loans. But the reverse is true, too — and that's what makes these loans so appealing right now. Instead of locking yourself into a fixed-rate loan at today's high interest rates, a variable-rate loan allows you to benefit from future rate drops.
“If you're forced to take a loan out right now, it probably should be a variable, in my opinion,” says Howard Dvorkin, founder of Debt.com.
Even though he's usually not so high on them, Dvorkin says adjustable-rate mortgages are currently more appealing than fixed-rate products because the Federal Reserve has signaled that it’s soon going to drop benchmark interest rates, or the rates at which banks lend to one another. That means there’s a good chance you could get a favorable adjustment when your interest rate is recalculated.
There's also the boon of some immediate savings, since adjustable-rate mortgages, also called ARMs, typically have lower initial rates than fixed-rate mortgages. But that rate only lasts for a few years. That's where the risk (and lack of popularity) comes in: when your rate is adjusted, your monthly payments can increase by hundreds of dollars.
While rates are likely to fall soon, the duration of this decline and the future rate environment over the next 5 or 10 years is unknown. Therefore, experts emphasize that even in today's high rate environment, adjustable-rate mortgages are only viable for borrowers with some financial flexibility.
The case for adjustable-rate mortgages right now
Today’s homebuyers have every reason to envy current homeowners who have fixed-rate mortgages in the three-percent range — a low-rate, fixed-rate loan is inarguably the best type of debt. But because that’s not possible right now, borrowers are putting all options on the table.
Last fall, when mortgage rates were nearing 8%, adjustable-rate mortgages made up 10.7% of mortgage activity, according to an analysis by Virginia Relators. That's compared to just 3% of mortgages in December 2021, when rates were near historic lows.
There wasn't a great argument for adjustable-rate mortgages before 2021 because the Fed couldn't cut benchmark rates any lower than 0%, which was the level for most of 2020 and 2021 until inflation accelerated. But the interest rate environment is very different now, and it's possible that rates will be cut in 2024 due to cooling inflation. That would be good news for borrowers with adjustable-rate mortgages.
DeAnna Adinolfo-Rivera, senior vice president and regional sales manager at Hamilton Home Loans, says while fixed rates are the best option for the majority of people, more mortgage borrowers are going with adjustable-rate loans because interest rates are unbearably high. “People are trying to find relief,” she says.
However, Adinolfo-Rivera says buyers should also consider other options, like asking for a rate buydown, that can achieve the same goal of lowering monthly payments in the near term without the long-term risks of an ARM.
A mortgage borrower can end up in serious financial trouble if their monthly payments soar on an adjustable-rate mortgage and their income doesn't grow commensurately, she says.
How adjustable-rate mortgages work and when they’re a good idea
Adjustable-rate mortgages are more complicated than other types of variable-rate loans. With an adjustable-rate mortgage, borrowers get an introductory interest rate for a number of years, and then the rate adjusts every six months or every year based on benchmark interest rates.
A common form is a 5/1 ARM mortgage, which means the intro period is 5 years and then the rate is adjusted every year after that. (A 5/6 ARM would have adjustments every six months.)
Right now, the average rate for 5/1 ARMs is 6.14%, which is 0.61 percentage points lower than the current average rate of 6.75% for fixed-rate mortgages, according to the Mortgage Bankers Association. (Both rates are based on 30-year loan terms.) That difference would shave $160 off the monthly payment for a $400,000 house.
This is a relatively normal gap: Intro rates on 5/1 ARMs are usually 0.5 to 1 percentage points lower than fixed rates.
Rates almost always increase after the intro period. But if benchmark rates fall significantly your rate could go down, meaning you can essentially get a lower rate on your mortgage without having to go through the process, or costs, associated with refinancing.
But be aware that because of the way lenders calculate the rate after the intro period, a small drop in benchmark rates won't be enough to shrink your payments. The Fed would have to aggressively cut rates, and they'd have to stay low even after the intro period, for you to really feel the benefits.
If the Fed doesn't aggressively drop rates, there are limits on how much your rate can increase. The maximum increase is typically 2 percentage points for the first adjustment and 1 percentage point for subsequent adjustments, up to a lifetime increase of 5 percentage points.
Even just that initial adjustment can be very painful for borrowers. On a $400,000 balance, a 2 percentage point adjustment would cause your monthly payment to go up more than $500.
To avoid these adjustments, borrowers often refinance or sell their homes before the end of the intro rate period. In fact, the best candidates for adjustable-rate mortgages are generally considered to be borrowers who anticipate selling or refinancing in a number of years, not decades, Adinolfo-Rivera says.
For these borrowers, an ARM can lower their monthly payments during the intro period and they'll never pay the (potentially higher) post-adjustment rate. This strategy only works if you have enough funds to either pay for refinancing costs or afford higher monthly payments after adjustments. And again, the approach is risky: A home price collapse could delay your decision to sell or a bad interest rate environment could make it hard to refinance in a five-year timeframe.
So, should you take out an adjustable-rate mortgage right now? An ARM can be "a great vehicle for a person who wants to avoid the higher interest rates,” Adinolfo-Rivera says. But, she adds, they really only work for people who have a higher risk tolerance or those who plan to sell or refinance within a few years.
For everyone else, the tried-and-true fixed-rate mortgage is still best.
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