With the traditional start to the home-selling season just starting, would-be homebuyers may be a bit jittery watching mortgage rates. Since the beginning of the year, rates have increased nearly a half-point to just under 4.5% and are expected to climb as homebuying gets underway in earnest.
If fixed rates on the conventional 30-year home loan hit 5%—likely to occur in the summer given the recent trend—that’s when more homebuyers will weigh the advantages of an adjustable-rate mortgage, ARMs for short, says Scott Sheldon, a senior loan officer at New American Funding in Sonoma County, California. “That will be the tipping point,” he says.
But these specialized mortgages aren’t for everyone, despite some advantages. Here’s what you should know.
What are ARMs?
Adjustable-rate mortgages offer a fixed rate for an introductory period—typically for five, seven or 10 years—before the rate changes based on an index that it tracks, such as LIBOR. How often an ARM’s rate adjusts depends on the loan’s parameters. For instance a 5/1 ARM’s rate is fixed for the first five years and then adjusts once a year. Rate hikes are capped, too, so borrowers don’t face steep increases in their monthly payment.
The advantage is, for the same loan amount, the initial fixed rate on ARMs is usually lower than the 30-year home loan rate, which is fixed for the entire term. That means the initial monthly payment on an ARM is also lower. For instance, at current rates, the monthly principal and interest payment on a 5/1 ARM for $200,000—with 20% down payment—is $746. On a 30-year fixed home loan, it’s $803.
ARMs got a bad rap—deservedly so—after the housing bubble burst in 2006. Instead of five-, seven-, or 10-year fixed-rate periods, the initial rates on those ARMs reset after one or two years. They also came with stiff prepayment penalties and no caps on rate hikes, and allowed borrowers to make monthly payments that didn’t even cover the loan’s interest, ballooning how much was owed. These questionable features have largely been eliminated—for now.
Who’s it good for?
ARMs are best for borrowers who plan to sell their home before any rate hikes can offset the savings they got from the lower payment in the first years. Those who can reliably expect their income to increase before the first hike sets in—such as a resident-turned-doctor—are also good candidates.
The buyer should be financially savvy, and have good income, low payment-to-income ratio, and a substantial amount of liquid reserves, says Sheldon. “The one client of mine who recently inquired about an ARM: she is selling the property in seven years to her children and doesn’t want to pay a premium for 30-year loan,” he says. “She is also financially strong, too.”
Big drawback: Risk
In exchange for a lower initial interest rate and monthly payment, ARMs require that you take on more risk. If home values decline or you hit financial difficulty, you may not be able to refinance or sell your home before the rate increases start. Getting trapped in an unaffordable ARM was the undoing of many homeowners who lost their homes to foreclosure during the housing crash. It’s important to note, again, that the ARMs of that era were far riskier.
If you want predictability and low risk, a fixed-rate mortgage provides just that. Monthly payments on these home loans don’t change throughout the life of the mortgage. You’ll pay slightly more in interest to get greater security and a payment that fits your budget. The other advantage: You’ll likely earn more income in the future, so the fixed payment becomes even more economical as time goes on. Interest rates also are expected to increase into 2020—barring a destabilizing event like a recession. Locking in a rate now for 30 years is financially sound, too.