Financing with an adjustable-rate mortgage
Q: Mortgage rates more than doubled during 2022. Given the increase we’ve seen with fixed-rate mortgages doesn’t it make sense to finance with an adjustable-rate mortgage?
A: A growing number of borrowers plainly think that adjustablerate mortgages — ARMs — are an attractive financing option. According to Joel Kan, vice president and deputy chief economist with the Mortgage Bankers Association, ARM originations represented 12.8% of all applications in mid-October, the highest share since March 2008.
“ARM loans,” Kan said, “continue to remain a viable option for borrowers who are still trying to find ways to reduce their monthly payments.”
There are several reasons to consider ARMs.
First, a quick look at rates tells much of the story. In late October, according to Freddie Mac, the typical fixedrate mortgage was priced at 7.08% versus 5.96% for 5/1 adjustables — loans that have a fixed-rate for five years and then vary each year thereafter. Borrow $250,000 with fixed-rate financing and the cost per month for principal and interest is $1,677. With an ARM the cost falls to $1,492 for five years. In year six and beyond the monthly cost can rise or fall.
Second, the lower initial ARM cost is a big deal for many borrowers. The smaller monthly cost saves the borrower $185 a month in cash in our example, or $2,220 a year. In turn, ARM borrowers are able to reduce their monthly debt-to-income ratio (DTI), a key measure used by lenders to determine who gets financing and who doesn’t.
Third, ARMs have more upside risk than fixed-rate financing because future rates and monthly payments can rise. If monthly costs go up and income remains steady or declines, such higher loan expenses can be a burden.
That said, ARM risk is limited by several factors.
There are caps in place that limit annual and lifetime rate increases.
Loan size will decrease over time with amortization, the monthly debt reduction that occurs with each payment. The result is that when ARM rates do adjust the new payment is based on less debt.
For instance, in our ARM example the loan balance drops to $232,521 after five years. If the interest rate goes up to 7.5% in year six, 25 years remain on the loan term and the monthly payment goes to $1,718. That’s a cost increase of $226 per month. However, think about what you earned five years ago. Hopefully, the higher expense will be offset with a larger income.
Borrowers can get a longer start rate if they elect, say seven or 10 years rather than five. Longer start rates mean more risk for lenders, so rates are likely to be higher.
Ask loan officers to provide today’s rates for three-, five-, seven- and 10-year ARMs and for fixed-rate financing. What’s the maximum ARM payment after the start rate ends? Be sure to look not only at interest rates, but also at the fees, points and charges associated with each mortgage option. Check the total cash costs for the loan after five years.