In response to rising mortgage rates, many of today’s homebuyers have been turning to adjustable-rate mortgages, or ARMs. The share of ARM loans jumped from around 3% in early January to nearly 11% in May, levels that haven’t been seen since 2008, according to the Mortgage Bankers Association.
Adjustable-rate mortgages typically come with lower initial interest rates and monthly payments than traditional fixed-rate mortgages, but the repayment terms can change over time. Since your mortgage rate may rise, there’s an inherent risk that your monthly payments and overall loan costs will be higher when the fixed-rate period ends.
“Many clients in the marketplace are taking advantage of the cash-flow benefits that the lower rate provides,” says Matthew Vernon, head of retail lending at Bank of America.
If you’re considering an ARM for your next home purchase, here’s what you need to know.
What Is an Adjustable-Rate Mortgage?
The most common type of adjustable-rate mortgage is a hybrid ARM, which begins with a fixed-rate period before the rate can adjust. This type of ARM is “a great option for clients that either may sell or plan to refinance within those periods,” Vernon says. Here’s how it works:
— Your interest rate and payments are fixed for an initial period. The fixed-rate period is the first number in your ARM, which usually lasts five, seven or 10 years. With a 5/1 ARM, your initial mortgage rate and payment amount will be in effect for five years before the lender can adjust it.
— Your interest rate and payments can change periodically. The adjustment period is the second number in your ARM. A 10/1 ARM means your rate can be adjusted once per year after 10 years. If the second number is a six, such as a 7/6 ARM, your rate can change every six months after the fixed period.
— The amount your rate can change may be capped. A periodic adjustment cap limits the amount your rate can increase per adjustment period. Alternatively, a lifetime cap determines how much your interest rate can increase over the life of the loan.
— Your monthly payments may be capped. Some ARMs have a payment cap, which protects your mortgage payment from increasing past a certain point. For example, a payment cap of 6% on an ARM with a $1,500 payment means that your new payment can’t exceed $1,590 when the rate adjusts.
Additionally, there are interest-only ARMs and payment-option ARMs. With an I-O ARM, you pay only the interest for a certain number of years — after that, your payment will increase because you’ll begin paying the principal balance as well as the interest. And importantly, your principal balance will remain the same during the interest-only period, limiting your ability to build equity.
With a payment-option ARM, you choose from multiple payment options each month, such as traditional principal and interest payments or interest-only payments.
Is an ARM a Good Idea in 2022?
With so many homebuyers today turning to adjustable-rate mortgages, you may be wondering if this home loan option is right for you.
First, you need to consider where rates may be at the end of your fixed-rate period. But since no one can predict long-term interest rate trends with complete accuracy, there’s always the risk that rates may be much different in five or 10 years than you expected.
You should also carefully consider your unique financial situation when choosing between a fixed-rate mortgage and an ARM, according to Peter Boomer, executive vice president at PNC Bank.
“It’s worth the risk if an individual doesn’t plan on being in their home long-term, if the individual thinks rates may go down in the future, or if the individual is considering substantially paying down their mortgage in the near future,” says Boomer.
Additionally, Boomer says that homebuyers may consider an ARM if they expect a substantial boost in their income before the next adjustment period, when monthly payments are likely to increase. Still, it’s important to communicate with your lender about your home loan options, since there’s no one-size-fits-all strategy that applies to all mortgage applicants. Here are a few questions you should ask during the process:
— Is there a fixed period? If so, how long does it last?
— How often can the rate adjust?
— Are there limits to how much the rate or monthly payments can change?
“A borrower should work with their lender to do a full comparison of all ARM loan options against fixed-rate options to find the right match,” says Boomer.
Current ARM Rates vs. Fixed Mortgage Rates
Mortgage rates today are much higher than they were a year ago — or even a few months ago — and that applies to both adjustable and fixed rates.
The average 30-year fixed mortgage rate was 5.81% for the week ending in June 23, according to Freddie Mac. That’s up from around 3% at the beginning of 2022. Even for 15-year fixed mortgages, rates have risen from 2.43% in early January to 4.92% currently.
Similarly, the average rate for a 5/1 ARM increased from 2.41% at the start of the year to 4.41% by late June. And while ARMs may offer the lowest initial rates of any mortgage product now, that rate can adjust significantly by the end of the five-year fixed period.
In terms of where mortgage rates will be in the future, a few industry groups offer research-backed predictions. The Mortgage Bankers Association forecasts that 30-year fixed mortgage rates will average 5% in 2022 before dropping over the next few years, to 4.8% in 2023 and 4.4% in 2024. On the other hand, Freddie Mac speculates that 30-year fixed rates will rise between 2022 and 2023, from 4.6% to 5%.
Alternative Ways to Combat Rising Mortgage Rates
While an adjustable-rate mortgage may help you save money initially, not all homeowners are willing to take on the additional risk that rates will rise during the life of the loan. But thankfully, ARMs aren’t your only way to handle rising interest rates. Here are a few alternative strategies to consider:
Lock in your mortgage rate as soon as possible. Most lenders let you lock in your mortgage rate when you have a signed home purchase agreement, typically without an additional fee for a 30-day period. This can protect your rate from rising if market conditions change while you close on your home. You may be able to extend your rate lock for a longer period for a fee, typically a set percentage of the loan amount.
“We will continue to see high volatility in the rate market, but buyers on the fence should consider pulling the trigger and locking in a rate now before they go higher,” says Michael Brown, senior loan officer at Churchill Mortgage.
Save up for a bigger down payment. Coming prepared with more cash toward your home purchase can lower your risk to the lender, which can lead to lower mortgage rates. If you can afford to wait and save up 15% down instead of 5% down, for instance, you may qualify for more favorable rates. And if you can afford a 20% down payment, you’ll also save on private mortgage insurance.
Choose a shorter repayment term. The popular 30-year mortgage term may offer you the lowest monthly payments, but interest rates tend to be much higher for this home loan option. By switching to a 15-year fixed-rate mortgage, you may be able to lock in a much lower interest rate and save significantly on interest charges over the life of the loan since you’re making fewer interest payments.
Compare mortgage rates across multiple lenders and loan types. Mortgage interest rates can vary greatly between lenders, which means it can pay to shop around for the lowest rate possible before formally applying. Mortgage preapproval will slightly lower your credit score, but you can minimize the negative impact by limiting your rate shopping to a 45-day period.
You should also compare rates for different mortgage options, such as FHA versus conventional. If you’re a veteran, you may qualify for the lowest rates through a VA loan.
Buy mortgage discount points. If you plan on staying in your home for a long time, such as 10 years or more, it may be worthwhile to purchase discount points through the lender. This is a set percentage of your loan amount that allows you to lower your mortgage rate.
Make sure you do the math to determine where your break-even point is, which is where the interest savings offset the cost of mortgage points.
More from U.S. News
As Fixed Rates Rise, Should You Consider an Adjustable-Rate Mortgage? originally appeared on usnews.com