After the sub-prime market crash in 2008, the term “adjustable-rate mortgage” (or just “ARM”) has almost become a curse word in the world of finance. However, experienced mortgage lenders know that it is sometimes a better solution compared to a traditional fixed-rate mortgage. ARMs have made a slight comeback in recent years and are much safer with today’s increased regulations, but are still not promoted much publicly.
Fixed vs. Adjustable Mortgages
It’s easy to understand the appeal of a fixed-rate loan. You are able to lock in a low interest rate for the life of the loan. If rates go down significantly, you can always just refinance—right? Well, the second statement isn’t as simple as it sounds. We’ll cover that topic a little later in the article. The first statement is definitely the primary reason why home buyers desire fixed mortgages.
The appeal of fixed-rate loans has been even higher in the past year with record-low mortgage rates. Rates have been steadily on the rise as the economy recovers from the pandemic, so what does that mean for the prospect of an adjustable-rate mortgage? People immediately assume that rising rates are bad news for an ARM, and on paper this is very true. In practice, however, it’s not always so cut and dry.
Some mortgage experts are contending that ARMs could actually be better for home buyers in certain situations. A good example is a borrower who plans to move within the next 5-7 years.
What is an ARM?
First, it helps to truly understand what an adjustable-rate mortgage is. Most ARMs will typically have fixed interest rates for the first five years—sometimes as many as seven or 10 years. After that, the mortgage rates will increase or decrease based on the prevailing interest rates—usually adjusting every six months over the life of the loan. A 30-year ARM follows the same amortization schedule as a 30-year fixed mortgage, so the ratio of interest-to-principal in your monthly mortgage payments will stay roughly the same with either loan.
The important thing to note is that most ARMs start with lower interest rates than fixed-rate mortgages. Because the adjustable-rate mortgage offers more flexibility and long-term market correction for the lender, they can offer lower average rates at the beginning of the loan. This wasn’t exactly the case during the pandemic, but it is becoming the case again as mortgage rates rise and the economy recovers.
When an ARM Might Make Sense
Let’s revisit our scenario of a home buyer who plans to move within 5-7 years of purchasing their property—using today’s average mortgage rates. They can qualify for a 30-year fixed loan at 3.0% and lock in that rate for the entire life of the loan. If rates keep going up, then they are protected. This is good news, especially if they end up staying in the house for the next 30 years or until the loan is paid off.
However, they are more likely to move in 5-7 years according to their plan. They might be able to qualify for a seven-year adjustable-rate mortgage at the prevailing average rate of 2.375%. This means they are paying a lower mortgage rate for the first seven years of the loan. The differences in these rates equates to roughly $100 a month in savings. Over a seven-year period, that adds up to approximately $8,400 in savings!
Now, if the seller decides to stay in their home longer than the seven years, then they are subject to the prevailing mortgage rates seven years from now. They could be much higher. They could be even lower. That we can’t quite predict.
Can I Refinance an ARM?
As for refinancing, that is always an option for either type of mortgage loan if rates fall even further in the future. Just know that getting approved for a home refinance isn’t a guarantee. When rates drop, there is always a lot of competition from other homeowners trying to refinance. Every time we see a significant mortgage rate decrease, we get a spike in refinance applications. Lenders can afford to be pickier and not every borrower will be approved. We’re not saying you shouldn’t try to refinance when the conditions are ideal. We’re just saying it’s not necessarily a walk in the park to lower your rate overnight.
Also, we must make it clear that ARMs aren’t for everyone. Fixed-rate loans are always a safer long-term bet. It really depends on the borrower’s financial situation and their homeownership plans. We all know plans change, so an adjustable-rate mortgage may not be the best solution in many cases.
It always pays to research your mortgage lending options and talk with a mortgage advisor who can review your situation and help you make the right financial decisions. Contact Transparent Mortgage today at (619) 701-3906 or email me personally at email@example.com