Disclaimer: Good Day, Readers. WealthBuildingPowers blog is a financial literacy/competency blog and does not provide specific investment recommendations.
ARE ADJUSTABLE-RATE MORTGAGES {ARM} RIGHT FOR YOU?
As mortgage interest rates increase, more people are applying for an Adjustable-Rate Mortgage {ARM}.
Let’s look at the differences in fixed-rate versus adjustable and focus on ARMs risk.
FIXED-RATE: A fixed-rate mortgage locks the interest rate for a set period (typically 15, 20, or 30 years).
ARM: Starts with a lower fixed interest rate for three to 10 years, followed by periodic (typically annually) rate adjustments.
WHEN CONSIDERING AN ARM UNDERSTAND THE RISK
- The average fixed rate on a traditional 30-year mortgage is 5.09%, up from below 3% in November and its highest since late 2018.
- The initial rate on a 5/1 adjustable-rate mortgage is 4.04%.
- Here’s what to know about how these mortgages work.
With an ARM, as it’s called, the appeal is its lower initial interest rate compared with a traditional 30-year fixed-rate mortgage. Yet down the road, that rate can change, sometimes not to your benefit.
Interest charged on mortgages
Average interest on a 30-year fixed-rate mortgage vs. initial rate on a 5/1 adjustable-rate mortgage
A line chart shows the changes in the interest charged on 5/1 adjustable mortgages and on 30-year fixed-rate loans from June 2012 through May 2022.
With these mortgages, the initial interest rate is fixed for a set amount of time. After that, the rate could go up or down, or remain unchanged. That uncertainty makes an ARM a riskier proposition than a fixed-rate mortgage. This holds true whether you use an ARM to purchase a home or to refinance a loan on a home you already own.
If you’re exploring an ARM, there are a few things to know.
For starters, consider the name of the ARM. For a so-called 5/1 ARM, for instance, the introductory rate lasts five years (the “5”) and after that the rate can change once a year (the “1″).
Some lenders also offer ARMs with the introductory rate lasting three years (a 3/1 ARM), seven years (a 7/1 ARM) and 10 years (a 10/1 ARM).
Aside from knowing when the interest rate could begin to change and how often, you need to know how much that adjustment could be and what the maximum rate charged could be.
Mortgage lenders employ an index and add an agreed-upon percentage point (called the margin) to arrive at the total rate you pay.
So if the index used by the lender is at 1% and your margin is 2.75%, you’ll pay 3.75%. After five years with a 5/1 ARM, if the index is at, say, 2%, your total would be 4.75%. But if the index is at, say, 5% after five years? Whether your interest rate could jump that much depends on the terms of your contract.
An ARM generally comes with caps on the annual adjustment and over the life of the loan. However, they can vary among lenders, which makes it important to fully understand the terms of your loan.
- Initial adjustment cap. This cap says how much the interest rate can increase the first time it adjusts after the fixed-rate period expires. It’s common for this cap to be 2% — meaning that at the first-rate change, the new rate can’t be more than 2 percentage points higher than the initial rate during the fixed-rate period.
- Subsequent adjustment cap. This clause shows how much the interest rate can increase in the adjustment periods that follow. This number is commonly 2%, meaning that the new rate can’t be more than 2 percentage points higher than the previous rate.
- Lifetime adjustment cap. This term means how much the interest rate can increase in total over the life of the loan. This cap is often 5%, meaning that the rate can never be five percentage points higher than the initial rate. However, some lenders may have a higher cap.
An ARM may make sense for buyers who anticipate moving before the initial rate expires. However, because life happens and it’s impossible to predict future economic conditions, it’s wise to consider the possibility that you won’t be able to move or sell.
PROS AND CONS OF AN ADJUSTABLE-RATE MORTGAGE
ARM PROS
Lower payments in the fixed-rate phase: An ARM offers potential savings in the initial, fixed-rate period. Standard ARM terms are 3, 5, 7, and 10 years.
Flexibility: If you plan to move or sell the house, you can enjoy the ARM’s fixed-rate period and sell before the fixed-rate period expires.
Rate and payment caps: ARMs may have several types of caps, limiting the maximum increases in your mortgage rate and the size of your payment. These include caps on how much the rate can change each time it adjusts and the total rate change over the loan’s lifetime.
Payments could decrease: If interest rates fall and drive down the index against which your ARM is benchmarked, your monthly payments could drop.
ARM CONS
Your payments could increase: When interest rates rise, your payments will likely increase after the adjustable period begins. Some borrowers will have trouble making the larger payments.
Unplanned Economic Changes: Borrowers MUST be prepared when interest rates increase and your monthly payments grow. If the market corrects and home values drop, you could be underwater on the house and unable to get refinance your ARM.
Potential Loss of Your Home: If you can’t make the payments after the fixed-rate phase of the loan, you could lose your home.
Prepayment penalty: Read the fine print. Some ARMs come with a prepayment penalty. This is a fee that can be charged if you sell or refinance the loan. Choose a lender who offers a loan without this penalty.
ARMs are complex: ARMs have complicated rules, fees, and structures. These complexities can pose risks for borrowers who do not fully understand all risks.
CONCLUSION – ARE ADJUSTABLE-RATE MORTGAGES RIGHT FOR YOU?
I used an ARM mortgage twice. On one loan, the rate decreased (pleasant surprise) after the introductory period; on the second, it increased. While I understood the risk, I was still nervous and thrilled to refinance those loans to fixed rates!
QUESTIONS TO ASK
- Can you afford the WORSE CASE revised payment if the rates keep increasing and you cannot refinance? This is how many people lose their homes to foreclosure.
- If married, can you afford that payment on one income?
- What if you or your partner lose your job for six months or longer?
- Look at worse-case scenarios and decide if the savings are worth the risk of losing your home and your down payment.
Before getting an ARM, calculate the maximum payments each year following the introductory period. Can you afford those payments even in THE WORSE OF TIMES?
To gain control over inflation, the Federal Reserve will keep pushing rates up in 2022, and mortgage rates will continue to climb. What goes up eventually goes down. The question is, when will mortgage rates return to a lower rate?
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I am a proud nerd (as my beautiful wife and daughter have told me) investment and finance blogger with an N.C. State, Chemical Engineering, University Rutgers, MBA and Harvard University, Advanced Management education.
I left a corporate career because I desired to make a difference as a speaker and writer. I was blessed to be coached and mentored by strong women and men in my family and professional life. It is my time to serve and give back.
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I started my first business at ~13 years of age (a small but brilliantly created plant nursery). I am a successful investor in stocks, options, real estate and am happy to share my finance and investment lessons. I am NOT a licensed financial advisor. Please do not construe my suggestions on this blog as recommendations for your situation. As an investor, you must establish your risk/loss tolerance. Investment in any asset involves risk, including complete loss.
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