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Though ARMs start off with temptingly low rates, you need to understand how they work before you take one out.
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ARMs are making a comeback, as housing affordability challenges and rising mortgage rates drive more home buyers to adjustable-rate mortgages, which often offer a lower starting interest rate. “With rates on fixed-rate mortgages running close to 6% and likely higher for less-qualified buyers, getting an ARM to snag a rate that’s south of 5% looks much more appealing,” says Kate Wood, home expert at Nerdwallet. Indeed, rates on 5/1 ARMs average about 4.3%, Bankrate data shows. You can see the lowest rates you may qualify for here.
Data from the Mortgage Bankers Association shows that the ARM share of applications now stands at over 10%, compared to less than 4% at the beginning of this year. What’s more, “as of March 2022, the ARM share accounted for 13% of the dollar volume of conventional single-family mortgage originations, a threefold increase since January 2021,” Corelogic notes. And the popularity of ARMs may continue, as many pros say mortgage rates will increase: “If the mortgage rates on fixed-rate mortgages continue to increase, “the share of loans originated with an ARM will likely increase as well,” concludes Corelogic.
What is an adjustable-rate mortgage and how does it work?
First of all, adjustable-rate mortgages are just that — adjustable, meaning the interest rate and monthly payment fluctuates. Then when the introductory period expires, the interest rate adjusts to current market rates. With a 5/1 ARM the interest rate is fixed for the first 5 years, and then switches to an adjustable rate for the remaining 10- or 25-years.
Who does an adjustable-rate mortgage make sense for?
The primary candidates for an ARM are borrowers who plan to sell before the end of the fixed-rate period of the ARM (that period is typically 5-7 years), thereby not exposing themselves to the risk of the potential rising rate, says Scott Krinsky, partner at real estate law firm Romer Debbas. “This also includes borrowers with a lot of liquidity looking for short term access to additional funds at the lowest possible rate and with the ability to pay off the mortgage prior to any potential rate hikes,” says Krinsky. You can see the lowest rates you may qualify for here.
And Jacob Channel, senior economist at LendingTree says those who might consider ARMs want lower introductory rates than what they’d find on a 30-year fixed-rate mortgage and don’t mind the idea of their monthly mortgage payment changing over time.
What are the pros and cons of an adjustable-rate mortgage?
The lower introductory rate is the big draw of an ARM, and what’s more, if rates drop after your fixed introductory period, you could end up with a smaller monthly payment than you started with. You can see the lowest rates you may qualify for here.
On the other hand, ARMs are much more unpredictable than fixed-rate mortgages and if rates increase, your monthly payment can become significantly larger. “If rates continue to increase, then once the introductory period ends, someone with an ARM could end up spending more money than they would had they gotten a fixed-rate mortgage,” says Channel.
While an ARM could be beneficial to borrowers who only plan to be in a home for 5 to 7 years, even that scenario is not without risk. “If your timetable changes, you could find yourself in a loan that will be pricing upward and increasing your monthly payments and there is no guarantee of being able to refinance into more favorable terms years from now,” says Greg McBride, chief financial analyst at Bankrate.
That’s why, says Channel, “It’s important for anyone thinking about an ARM to be sure that they have enough money to handle a situation where their rate increases and they need to spend more on their mortgage.” An increase in a mortgage rate of even a single percentage point can increase your monthly mortgage payment by well over $100, depending on factors such as where your rate ends up and how big your mortgage is.
Because the rate adjustment can have more risk for the borrower, Paul Thomas, Zillow vice president of capital markets for mortgages, says “the unknown potential increase can make budgeting for this loan difficult. But new regulations enacted after the housing crisis have improved underwriting standards and transparency of ARM products, helping to improve a borrower’s ability to repay the loan after the rate resets.”
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