The Federal Reserve has raised its benchmark interest rate six times so far in 2022. And with each Fed rate hike, lenders tend to follow suit and increase loan APRs are well. As a result, would-be homebuyers throughout the U.S. have been facing consistent mortgage rate increases over the last seven months.
In response to rising mortgage rates, adjustable-rate mortgages (also called ARMs) have begun to increase in popularity once again. According to the Mortgage Bankers Association’s Weekly Mortgage Applications Survey, during the week ending November 4, 2022, 12% of mortgage applications received in the United States were for ARM loans.
An ARM offers a prospective homebuyer a more affordable way to get into a new home—at least at first. Yet it’s important to examine the risks associated with this type of mortgage before you proceed. Choosing an ARM might save you money on the front end, but it’s not the right fit for everyone. Depending on your situation, you might be better off selecting a fixed-rate mortgage instead. Here are some things to consider before getting an ARM, from myFICO.
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How an Adjustable-Rate Mortgage Works
An adjustable-rate mortgage has an interest rate that typically starts out at a lower fixed rate for an initial period of time. However, after the ARM’s initial fixed-rate period, the interest on the loan can adjust up or down at consistent intervals until the end of the loan term. And if the interest rate changes on your loan, your monthly payment amount could adjust too.
Often, the payments on an adjustable-rate mortgage may change on an annual basis according to the benchmark index rate to which the loan follows. But the rate adjustments could happen more often.
Depending on the terms of your ARM, there may be both periodic and lifetime interest adjustment limits. Periodic limits cap how much the interest rate may increase at once. Lifetime limits set a cap on the maximum interest rate you could have to pay overall.
The name of an ARM loan provides insight into its terms. Here are some examples.
- A 3/1 ARM begins with a fixed interest rate for three years and can adjust once a year thereafter.
- A 5/6 ARM begins with a fixed interest rate for five years and can adjust once every six months thereafter.
- A 7/1 ARM begins with a fixed interest rate for seven years and can adjust once every year thereafter.
How a Fixed-Rate Mortgage Works
A fixed-rate mortgage has an interest rate that remains the same throughout the life of the loan. The most common type of fixed-rate home loan is a 30-year fixed mortgage. However, lenders may offer 15-year and 20-year fixed mortgages as well.
In addition to your interest rate remaining the same with a fixed-rate mortgage, your monthly payment stays the same as well. So, you never have to worry about any payment surprises that you’ll have to figure out how to fit into your budget.
Risks and Drawbacks of Getting an Adjustable-Rate Mortgage
When interest rates rise, it can limit your options as a homebuyer—especially when rates increase multiple times as they have in recent months. With each Fed rate hike, you might find yourself qualifying for a lower loan amount. And if you’re someone who’s hoping to buy a home but hasn’t done so yet, seeing your home buying power shrink over and over again can feel quite frustrating.
You might be tempted in such a situation to apply for an adjustable-rate mortgage in an attempt to qualify for a larger loan amount. Yet there are some risks and drawbacks to this borrowing strategy that you should consider first.
With an adjustable-rate mortgage:
- You might need a larger down payment.
- Future payment increases might strain your budget.
- You might have trouble selling or refinancing down the road if the housing market shifts or your employment situation changes.
- Negative amortization might occur if monthly payments are insufficient to cover the interest due.
- A prepayment penalty might apply if you wish to refinance early.
When an ARM Might Be Worth Considering
In certain situations, an adjustable-rate mortgage might be worth considering (provided you’re comfortable with the risks). For example, if you know you only plan to stay in a home for a few years and want to boost your buying power, an ARM could be helpful. Some homebuyers like to take advantage of the lower interest rates that ARMs offer and pay extra toward their loan principal to try to pay off their mortgages faster.
If you’re trying to decide whether a fixed-rate mortgage or an ARM makes the most sense for you, myFICO’s “Which is better: fixed or adjustable” financial calculator can help you crunch the numbers. It’s also wise to compare interest rates from multiple lenders to make sure you get the best deal possible, regardless of the type of mortgage you choose.
Bottom Line
Adjustable-rate mortgages are becoming more popular in today’s mortgage environment. For some homebuyers, these loans could be a good fit. Yet it’s important to understand the unique risks that ARMs represent before you move forward with an application.
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