Adjustable rate mortgages are often overlooked by homebuyers, but thanks to high interest rates and changes in the economic environment, experts say these lesser-used loans could be an attractive option for some borrowers.
As the name suggests, adjustable rate mortgages are a type of loan in which the interest rate changes over time. When benchmark rates rise, interest rates on variable or variable rate loans also rise. But the opposite is also true: and that’s what makes these loans so attractive right now. Instead of locking yourself into a fixed rate loan at today’s high interest rates, a variable rate loan allows you to benefit from future rate drops.
“If you’re forced to take out a loan right now, it should probably be a variable, in my opinion,” says Howard Dvorkin, founder of Debt.com.
While he’s not usually as keen on them, Dvorkin says adjustable-rate mortgages are currently more attractive than fixed-rate products because the Federal Reserve has signaled it will soon lower benchmark interest rates, or the rates at which banks they lend to someone. another. This means there’s a good chance you’ll get a favorable adjustment when your interest rate is recalculated.
There’s also the benefit of some immediate savings, since adjustable-rate mortgages, also called ARMs, typically have lower initial rates than fixed-rate mortgages. But this rate only lasts a few years. This is where the risk (and lack of popularity) comes in: When your rate is changed, your monthly payments can increase by hundreds of dollars.
While rates are likely to fall soon, the duration of this decline and the future rate environment over the next 5 to 10 years is unknown. Therefore, experts point out that even in the current high rate environment, adjustable rate mortgages are only viable for borrowers with some financial flexibility.
The case of variable rate mortgages right now
Today’s homebuyers have every reason to envy current homeowners who have fixed-rate mortgages in the 3% range—a low-rate fixed-rate loan is arguably the best type of debt. But since this is not possible at the moment, borrowers are putting all options on the table.
Last fall, when mortgage rates were near 8%, adjustable-rate mortgages made up 10.7% of mortgage activity, according to an analysis by Virginia Relators. This compares to just 3% of mortgages in December 2021, when rates were near historic lows.
There were no big arguments in favor of adjustable-rate mortgages before 2021 because the Fed could not cut policy rates below 0%, which was the level for most of 2020 and 2021 until l inflation was not accelerating. But the interest rate environment is now very different and it is possible that rates will be cut in 2024 as inflation cools. This would be good news for borrowers with adjustable rate mortgages.
DeAnna Adinolfo-Rivera, senior vice president and regional sales director for Hamilton Home Loans, says that while fixed rates are the best option for most people, more mortgage borrowers are opting for adjustable rate loans because interest rates are unbearably tall. “People are trying to find relief,” she says.
However, Adinolfo-Rivera says buyers should also consider other options, such as asking for a rate drop, which can achieve the same goal of reducing short-term monthly payments without the long-term risks of an ARM.
A mortgage borrower can end up in serious financial trouble if his monthly payments on an adjustable-rate mortgage skyrocket and his income doesn’t grow commensurately, he says.
How adjustable rate mortgages work and when they are a good idea
Adjustable rate mortgages are more complicated than other types of adjustable rate loans. With an adjustable-rate mortgage, borrowers get an introductory interest rate for a certain number of years, then the rate adjusts every six months or annually based on benchmark interest rates.
A common form is a 5/1 ARM mortgage, which means the introductory period is 5 years and the rate adjusts annually thereafter. (A 5/6 ARM would undergo adjustments every six months.)
Currently, the average rate for 5/1 ARMs is 6.14%, which is 0.61 percentage points lower than the current average rate of 6.75% for fixed-rate mortgages, according to the Mortgage Bankers Association . (Both rates are based on 30-year loan terms.) This difference would reduce the monthly payment for a $400,000 home by $160.
This is a relatively normal gap: introductory rates on 5/1 ARMs are typically 0.5 to 1 percentage point lower than fixed rates.
Rates almost always increase after the introduction period. But if benchmark rates drop significantly, your rate could drop, meaning you can essentially get a lower rate on your mortgage without having to go through the process, or costs, associated with refinancing.
But keep in mind that, due to the way lenders calculate the rate after the introductory period, a small drop in benchmark rates will not be enough to reduce your payments. The Fed would have to cut rates aggressively, and they would have to stay low even after the introductory period, for you to really feel the benefits.
If the Fed doesn’t lower rates aggressively, there are limits on how much the rate can rise. The maximum increase is typically 2 percentage points for the first adjustment and 1 percentage point for subsequent adjustments, up to an overall increase of 5 percentage points.
Even just this initial adjustment can be very painful for borrowers. On a $400,000 balance, a 2 percentage point adjustment would increase your monthly payment by more than $500.
To avoid these adjustments, borrowers often refinance or sell their homes before the end of the introductory rate period. In fact, the best candidates for adjustable-rate mortgages are generally considered borrowers who anticipate selling or refinancing in a number of years, not decades, Adinolfo-Rivera says.
For these borrowers, an ARM can reduce monthly payments during the introductory period, and they will never pay the (potentially higher) post-adjustment rate. This strategy only works if you have enough funds to pay refinancing costs or afford higher monthly payments after adjustments. And once again, the approach is risky: a collapse in real estate prices could delay the decision to sell or an unfavorable interest rate environment could make it difficult to refinance within a five-year time frame.
So is it worth taking out a variable rate mortgage straight away? An ARM can be “a great vehicle for a person who wants to avoid higher interest rates,” says Adinolfo-Rivera. But, she adds, it really only works for people who have a higher risk tolerance or for those who plan to sell or refinance within a few years.
For everyone else the best solution remains the tried and tested fixed rate mortgage.
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