Cue the reemergence of the adjustable-rate mortgage. The proportion of mortgages that are adjustable-rate mortgages (ARMs) more than doubled to 10% in January 2022, up from only 4% in January 2021.
Increased interest in ARMs is no surprise, as they offer an initial rate that’s significantly lower than a standard 30-year mortgage. But what’s the catch for buyers? After all, ARMs were last this popular in the lead-up to the collapse of the housing market in the late 2000s. As an agent, when should you recommend an ARM, and when should you advise clients to stick to a traditional mortgage, even if it has a higher rate?
How Does an Adjustable-Rate Mortgage Work?
As ARMs occupy a larger share of approved mortgages, buyers are more likely to be familiar with them as a strategy to lower their initial rate. What buyers may not understand is that after the initial period – sometimes called a “teaser rate,” which typically lasts between three and 10 years – their interest rate and monthly payments fluctuate.
ARM rates are tied to a major index, such as the maturity yield on a one-year Treasury bill or the Secured Overnight Financing Rate. After the initial rate expires, mortgage lenders take the index rate and add a pre-agreed number of percentage points, called the margin. The margin stays the same, but the index rate fluctuates, and is out of your and your client’s control – though ARMs do come with a cap that insulates buyers from steep increases in monthly payments.
The most popular adjustable-rate mortgage is the 5/1 ARM – which means that the introductory rate lasts for five years, and the interest rate changes once every year thereafter. Let’s see how one looks in practice.
Your buyer needs to take out a $400,000 loan to purchase a home, having put an $80,000 down payment on a $480,000 property. A standard 30-year mortgage, which is known as a “fixed rate,” currently comes with about a 5% interest rate. Under this circumstance, your buyer would pay $2,147.29 every month for 30 years – adding up to $773,024.40 total over the course of the mortgage.
Under a 5/1 ARM, your buyer may be able to secure an initial, five year rate of about 3.5%. Over the first five years of the loan, they would pay $1,796.18 per month, which adds up to $107,770.80 – $21,067 less than the $128,837 they would pay with a fixed-rate mortgage.
After this, things get more complicated. While it’s possible that interest rates could be lower in five years, most experts consider it unlikely, as the Federal Reserve has announced and begun to implement an aggressive rate hiking schedule to combat inflation.
Even with a relatively low first-time adjustment of 1% and a favorable interest rate cap of 8.5%, monthly payments on this 5/1 ARM rise to a maximum of $2,817.96 per month. Overall, total 30-year payments on the 5/1 ARM would be estimated at $928,320, a full $155,296 more than a traditional, fixed 30-year loan.
When Does an Adjustable-Rate Mortgage Make Sense?
Clearly, adjustable-rate mortgages combine short-term gain with long-term risk. Your buyers can save money in the early stages of a home loan, but could be stuck with unfavorable, or at least unpredictable, mortgage rates for the brunt of their mortgage.
Whether an ARM is a sensible, responsible option depends entirely on the buyer’s circumstance. The first type of buyer most advantaged by an ARM is somebody who doesn’t plan on living in their home for long. If your buyer indicates that they plan to purchase and then sell their home in five years or less, an ARM will allow them to bank savings without worrying about the fluctuations of mortgage indexes.
In this vein, ARMs are a more normal option for people purchasing a “starter” home, because it allows them to build equity and pocket cash in advance of a more expensive home purchase.
For buyers who feel squeezed out of the red-hot housing market, ARMs can be an avenue to qualifying for a larger home mortgage. Some of these buyers may anticipate having a higher income in the future, or believe they will be able to refinance their mortgage later on when interest rates drop. These buyers have a higher tolerance for risk, and as long as you explain the potential downsides, opting for an ARM can be a reasonable option.
An ARM does not make sense for buyers looking to secure their “forever” home. For example, consider a married couple in their 30s who tell you they are searching for the home in which they will raise their family. They inform you they do not plan to leave this home for decades, and have settled, stable lives and careers in your local area.
For such buyers, an ARM would be a resoundingly poor choice. Instead, encourage these clients to pursue a traditional 30-year fixed mortgage, because it will afford them security and clarity.
ARMs are a similarly poor fit for buyers who have a low down payment, because a market correction and decreasing home values could leave them with inflated debt on a less valuable investment. Also, buyers who are purchasing a modestly priced home, especially those under $200,000, will only yield $100 or less per month during their initial ARM rate. Those savings likely won’t be worth the risk of rising mortgage payments in the future, making an ARM a questionable decision.
As with all aspects of being an agent, answering questions about adjustable-rate mortgages depends foremost on your ability to understand and respond to your clients’ goals and objectives.