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- Adjustable-rate mortgages have changed since their first appearance in the 1980s
- ARMs can help new buyers have lower monthly mortgage payments
- Fully understand what your are signing, how it works and what the worst-case scenario is
- ARMs can be a great option for millennials, who might not stay in a starter home very long
Adjustable-rate mortgages, or ARMs, were created as an option to the standard 30-year fixed-rate mortgage some 40 years ago.
With an ARM, a homebuyer is locked in to an often slightly lower interest rate for a five-, seven- or 10-year period. After the fixed term expires, the rate reverts to being flexible again, which can cause an increase in monthly mortgage payments.
Historically, ARMs were not always financially viable because rates could skyrocket from 5% to something like 18%. Now, five-year ARMs have a 2% cap, meaning the rate can only go up 2% at the end of the fixed period. The cap can be higher for longer-term ARMs. After that time the rate can change another 1% every six months for the life of the loan.
ARMs have been around for decades but haven’t been used much in the last several years because interest rates have been historically low and ARMs weren’t needed.
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But now, with interest rates steadily increasing, the ARM is coming back into play and oftentimes enabling younger buyers to become homeowners because rates are an average of 1% less than a typical 30-year fixed mortgage.
But mortgage lenders advise borrowers to proceed with caution and understand the worst-case scenario.
ARMs are complicated because there is some risk involved as well as a number of variables from person to person and lender to lender. But we spoke to several experts and came up with the top 3 things you need to know.
1. These aren’t your parents’ ARMs
Donna Rumpler, sales manager at Central Bank, said ARMs got a bad rap years ago because they came with all kinds of penalties and open-ended risk. That’s not the case anymore as ARMs have caps establishing the maximum amount a rate can change.
“The ARMs we have at the bank have no prepayment penalties and a buyer can transfer from the ARM to a fixed rate prior to their closing date if they need to,” she said. “This can give someone rate protection when building a home.”
Steve Medes, president at Wesley Mortgage, said today’s ARMs ideally are good for two types of people: someone who is fairly certain the time frame for a mortgage is short, and someone who is financially savvy and understands the complexities of the market.
“Today’s adjustable rate mortgages are protected a little bit,” he said. “Unfortunately in our industry, a lot of people are transactional and just want to get a loan closed, so they don’t explain them really well. It goes back to education and fully understanding what you are signing, how it works and what the worst-case scenario is.”
2. ARMs can save you money, but do your research
Adjustable-rate mortgages do offer an initially lower interest rate, which creates a lower monthly mortgage payment and in turn can enable a buyer to qualify to buy more house. However, there are a lot of factors to take into consideration before signing up for an ARM.
Rumpler worked with buyers recently who saved $258 a month with an ARM, compared to a 30-year fixed mortgage. Over the seven-year period of that ARM, the buyers will have saved a total of $21,700. They are buyers who know they will sell their home before the seven-year fixed period ends, so their risk is lower.
She added that the chance of a millennial staying in a home more than seven years is very small.
As Medes said, this is where it’s important that a buyer understands the worst-case scenario and doesn’t just look at the initial savings.
“I find in a lot of cases, people really don’t understand how these work,” he said. “You have to understand that after your initial fixed period ends, every six months your interest rate could change for the duration of the remainder of your mortgage.”
For example, on a $300,000 loan, for every 1% change in interest rate, the monthly payment increases by $200.
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3. The risk lessens if you sell or refinance
Even if the duration of a buyer’s mortgage is uncertain, as they near the end of an ARM’s fixed period, there are options to avoid fluctuating rates. ARMs today don’t have prepayment penalties, meaning a buyer has the option to refinance into a fixed mortgage at any point. That option, however, comes with closing costs that can be thousands of dollars.
Homeowners in this scenario have to look at what the best option going forward is. While refinancing or selling the home are options, living with the adjustable rate can be a valid option, too.
“As long as that person understands worst-case scenario, an ARM can be potentially a pretty good option for a first-time homebuyer,” he said. “Maybe you know you are going to be making more money in five years, but even if not, could you afford these changes if that didn’t happen? If so, then this is a good example of where an ARM could be good.”
Melonee Hurt covers growth and development at The Tennessean, part of the USA Today Network — Tennessee. Reach Melonee at mhurt@tennessean.com.
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