With mortgage rates remaining firmly above 6% for the foreseeable future, homebuyers are looking for savings. And they find them in adjustable rate mortgages, or ARMs.
The share of ARM applications reached 12.9% of total mortgage loan applications in September — the highest share since 2008, according to data from the Mortgage Bankers Association (MBA). At that time, 5/1 ARM rates averaged 5.66%, nearly a percentage point below the average 30-year fixed rate, the MBA said.
But despite their growing popularity, ARMs carry some risks and can sabotage a borrower’s ability to finance their home loan over the long term.
How ARMs Work
ARMs have a lower fixed interest rate for the first few years of the loan, making repayment more affordable compared to a 30-year fixed-rate mortgage. Once this period is over, the mortgage resets to a variable interest rate that changes annually or every six months (depending on the loan). This means that monthly mortgage payments may also increase or decrease.
Mortgage rates are generally expected to remain above 6% in the coming year and, coupled with high house prices, are putting a strain on buyers’ budgets. The current national average 30-year fixed rate was 6.23% as of Nov. 26, according to Freddie Mac. On the other hand, the The average 5/1 ARM rate is 6.07% as of December 3, bank rate data shows.
Using the current average interest rates above, here’s how much you’d save on monthly payments with an ARM compared to a fixed-rate loan of various amounts.
With a rate difference of 0.16% (6.23% fixed versus 6.07% ARM):
- $300,000 loan: Save $31/month ($1,865 over 5 years)
- $500,000 loan: Save $52/month ($3,108 over 5 years)
- $750,000 loan: Save $78/month ($4,661 over 5 years)
- Million dollar loan: Save $104/month ($6,215 over 5 years)
Jennifer Beestonexecutive vice president of national sales at Rate, says she rarely recommends ARMs to most borrowers.
“For conventional loans, I don’t think the rate advantage is worth the risk,” Beeston said.
Weigh savings and risks
In most cases, ARM borrowers refinance with a new fixed-rate loan or sell before their loan resets. But the math doesn’t always work in their favor in the long run.
“What people don’t realize is that with an ARM, you’re committing to requalifying for that loan if you decide to keep the home for an extended period of time,” she explained. In most cases, it is not beneficial for borrowers to maintain an ARM after the introductory rate period ends, especially in today’s high rate environment.
Qualifying for a new mortgage comes with another set of fees and closing considerations. For example, what happens if you move from paid employment to self-employment and cannot qualify for a new loan? Or what if you get divorced and can’t prove your ability to repay on one income? These are all questions to consider before embarking on an ARM, Beeston said.
“If you’re doing something like house hacking — buying a house, living in it for a few years with 3.5 percent down, then turning it into a rental — you want to do a 30-year fixed contract at the owner-occupancy rate,” Beeston said. “Second homes and investment properties will always have higher rates.”
During the Great Recession, when borrowers owed more on their mortgages than their homes were worth after their home values collapsed, millions of homeowners found themselves trapped in unaffordable home loans. If your home’s value declines, you cannot refinance your way out of an ARM when it adjusts because you will lack sufficient equity. It can also make it harder to sell your home if the value drops and you need to get out of an undervalued mortgage.
Who should consider an ARM?
Today’s ARMs typically have a fixed initial term of five, seven or 10 years, so they don’t pose the risk of prepayment shock as pre-2008 ARMs did, MBA Chief Economist Mike Fratantoni noted in a press release.
Beeston acknowledges that ARMs can make sense for some borrowers, particularly in the jumbo loan market where rate differences are greater.
“Half a percent on $100,000 is not worth the risk. Half a percent on $2 million? OK, let’s start talking about it,” she said.
The ideal ARM candidate plans to sell or refinance before the adjustment period, has stable, high income, maintains low debt-to-income ratios, and can absorb potential rate increases.
“If you have something on the horizon where it’s not a problem – you’re going to earn more, your job is secure – great,” Beeston said. “But if you are [maxed on] If you’re eligible right now and you don’t have anything on the horizon for a pay raise, it can be very dangerous.”
She warns that some lenders use ARM rates as bait without clearly showing actual payment differences or explaining the mechanics of the product. If a lender doesn’t show you the full calculations or pressure you into an ARM, that’s a red flag.
“When you’re talking to someone, it should be, ‘Here are your options,'” she said. “You have to ask a lot of questions and make sure you understand the product.”
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