Mortgage rates have risen faster this year than they have in decades.
The average 30-year fixed-rate mortgage has been hovering above 5% for more than a month, taking a toll on prospective homebuyers. While many hopeful buyers have bowed out of the market for now, some are exploring what once seemed like an unlikely option: adjustable rate mortgages, or ARMs.
The cost of financing a home has risen so much, so fast that many buyers can’t afford to buy a home with a traditional fixed-rate mortgage. The typical monthly payment on an average priced home with a 30-year fixed rate loan and 20% down is more than $600 higher now than at the start of this year – a 44% increase on principal and interest payments, according to Black Knight, a mortgage data firm.
While ARMs got a bad name during the housing meltdown of the late 2000s, stricter regulations and more transparency have made them less risky than they used to be. And ARMs typically offer lower rates, at least at first. While the average 30-year fixed-rate mortgage was 5.23% last week, a 5-year ARM was more than a percentage point lower at 4.12%, according to Freddie Mac.
ARMs offer a fixed rate for a set period – typically 5, 7 or 10 years – after which the interest rate resets to current market rates. A 5/1 ARM, for example, has a fixed rate for 5 years and then resets every year after that, while a 5/6 ARM is fixed for 5 years and then resets every 6 months. Loans reset based on a reference index like the Secured Overnight Financing Rate (SOFR) or the rate on short-term US Treasuries. There are also caps on how much a rate on an ARM can go up or down during each reset period and over the life of the loan.
“Many people are looking at ARMs as the best bridge or Band-Aid until rates come back down and they can refinance into a more competitive fixed rate,” said Melissa Cohn, regional vice president at William Raveis Mortgage.
The return of the ARM
For many buyers who lived through the housing crash, the mere mention of ARMs can cause them to shudder. Many of the problematic loans issued during the subprime crisis were ARMs. But at that time, these loans were being offered without verifying a borrower’s income, with features that obscured the full mortgage payment or with interest-only or “teaser” rates. Sometimes the total cost of the loan increased because borrowers’ payments weren’t even covering the interest on the loan (this is also known as negative amortization). Some ARMs reset after only two years.
Because some of these loans were made at 100% of the property value, a prepayment penalty and transaction costs would cause a borrower to be unable to sell the home without being underwater – meaning they would owe more than the house is worth.
“They were mutant loans,” said Luke Johnson, founder and CEO of Neat Loans, a fintech mortgage lender. “Lenders didn’t even know how much borrowers made. If a borrower needed to pay off the loan to get out of it by selling the home or refinancing, they weren’t allowed to without an egregious prepayment penalty. That is a way different atmosphere than what we are looking at now.”
Today’s ARMs require verification of a borrower’s income and typically require a debt-to-income ratio of no more than 50%. They also offer better payment transparency by requiring lenders to provide a form outlining the costs of the loan over time and the closing costs, said Cohn. Interest-only ARMs are still out there, she said, as well as loans that reset monthly rather than once or twice a year. She suggested steering clear of those kinds of products unless you are an experienced buyer or an investor.
“An ARM today you can look at as a fixed-rate loan for a shorter amount of time,” Cohn said. “A 7-year ARM looks, talks, walks like a fixed-rate loan for 7 years. There is no prepayment penalty on an owner-occupied home so you can refinance out of it in two months, three years or whenever you want.”
Johnson noted that the typical 5 to 7 year schedule for an ARM resetting is in line with when many homeowners are likely to move or refinance or to do a renovation once they have accumulated some equity in their home.
Fixed rate vs. ARM
The overwhelming share of loans are still fixed-rate mortgages, but ARMs are becoming more attractive in a higher rate environment. At the beginning of June just 8% of applications were for ARMs, according to the Mortgage Bankers Association.
While ARMs come with more risks, they may be more cost-effective in the near term.
A buyer purchasing a median-priced $390,000 home with 20% down that they expect to live in for 7 years will pay over $10,500 more during that time with a 30-year fixed rate loan at 5.23% than they would with a 5/1 ARM at 4.12% with the expectation that rates increase, according to numbers from Freddie Mac, which has a calculator borrowers can use to compare loans.
Payments on the fixed-rate loan would be about $200 more a month – at least until the rate of the ARM resets.
ARMs also often allow you to pay off more of the principal on the loan in those seven years, Johnson said. Generally homeowners with higher mortgage rates will pay more in interest rather than principal for a longer time than those with lower interest rates.
“You should be especially interested in this if you have a theory you’re going to live in your home 7 years, say, but not likely after that,” said Johnson. If you choose to refinance or borrow against the home, the ARM will allow you to have more equity.
“It matters even more for less affluent borrowers who put less down,” Johnson said. “When do they get rid of mortgage insurance? Could they refinance into a better loan program? Ask those questions – any legitimate loan officer can prepare information on those for you, given your circumstance.”
Know the risks
Still, even with shorter term savings, ARMs aren’t for everyone. For many people, a fixed-rate loan, even at 5% or above, may be a better fit.
Kaylin Dillon, a certified financial planner who runs her own firm in Kansas, says buyers should clear a couple bars before getting into an ARM, including having extra cash to throw at payments on a monthly basis.
“I only suggest getting an ARM if you can afford to make excess mortgage payments large enough to pay off the loan in full before the fixed rate period of the loan ends,” she said. “This way, you have paid off your home at the lower interest rate without the risk of a ballooning interest rate at the end of the fixed period.”
If the rising rates have put your dream house out of reach, maybe it is time to take a breather from the housing market, said Jay Zigmont, a certified financial planner and founder of Live, Learn, Plan based in Mississippi.
In order to avoid becoming house poor or risk falling behind on payments, Zigmont recommends buying a home once you are out of debt, have at least three months’ worth of expenses in an emergency fund, and can make a 20% down payment. He said a buyer’s goal should be to keep the house payment, including principal, interest, taxes, and insurance, below a third of your take home pay, even if banks approve you for more.
“You shouldn’t try to get fancy with your financing just to make your house ‘work’,” Zigmont said. He added that there is no guarantee that the value of the home will rise or that you will be able to refinance when the fixed term of the ARM ends.
If a buyer’s income is not expected to rise much and their monthly cash flow is already tight, taking on the possible burden of higher mortgage payments when an ARM resets is certainly a risk, said Cohn.
“What happens when the rate changes and you have to pay more each month? What happens if you lose your job and you can’t even afford to refinance?” said Cohn. “If you’re not willing to take on those risks, a fixed-rate is a better solution.”