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When Rates Rise – Is an ARM Mortgage a Good Idea?

What You'll Learn: What to Look at When Considering an Adjustable-Rate Home Loan.

EXPECTED READ TIME: 9 MINUTES

Our members will often ask, "Are adjustable-rate mortgages a good idea?" And like with most challenging questions,  the answer is, "It depends." You probably don't want to hear that, but it really does. Since the 2008 financial crisis, adjustable-rate mortgages or ARMs have gotten a bad rap. However, they can be an excellent option for some borrowers especially with rising home prices and bidding wars. Let's look at them a bit closer.

What Are ARMs?

An adjustable-rate mortgage (ARM) is a type of loan that provides borrowers with a lower rate for an initial fixed period. The terms are usually 3, 5, 7, or 10 years. After this initial period, the loan rates will adjust each year depending on market factors.

Most ARMs will use an index rate called the Secured Overnight Financing Rate (SOFR) to determine their adjustments. One good thing is that most ARMs will have a predetermined rate increase cap which is the maximum amount that a rate can increase in a single year. The cap is your worst-case scenario increase once you are past the fixed period.

You will see ARMs named with numbers that look like this: 7/6m

  • The first number, 7, is the fixed period number of years, and the second part, 6m, is the adjustment time, so there are adjustments every six months after the fixed period completes.
  • During an ARMs adjustment period, the rate will adjust using the following formula:

30 day average of SOFR (Index) + (Margin)

Over the last ten years, the margin has stayed around 2.74% to 2.76%. But the SOFR index's value varies. The New York Federal Reserve maintains the SOFR index, and you can access the current numbers here.

 

 

 

Adjustable-Rate Mortgage Pros & Cons 

 

The main advantage of an adjustable-rate mortgage is that during the fixed period, the rate for the mortgage will be lower (sometimes significantly) compared to a fixed-rate mortgage. 

Let's take a look at some example current rates:

 

Loan type

(Initial) Rate

30-year Fixed

4.25%

5/1

3.125%

7/1

3.25%

10/1

3.375%

 

ARMs rates are for the fixed period, then adjust

 

You can see the trends of ARM rates for the last year here.

These differences may not look significant, but they can result in savings over time. However, after the fixed period ends, you would have a rate based on the SOFR and the margin, resulting in your payment going up (or down). Many homeowners plan on refinancing before their loan adjusts.

If you are in a period of rising rates (as we are now in 2022), an ARM can lock in a lower rate, and you can watch the rate climb without worry until the fixed-rate period expires.

No one knows what rates will do. But with the help of Freddie Mac, we can take a look back at history to see what they've done in the past. From 1975 to 2021 (47 years), 19 years have seen rates above 8%, and all were before 2000.

The main con of an ARM is if rates climb too much, you would eventually overcome the savings you obtained during the fixed-rate period.

 

Adjustable-Rate Mortgage Risks

 

The most significant risk is that the rates will climb significantly after the fixed period. But remember, an ARM has "caps," limiting the amount that the rate can increase. Caps are your friend protecting you from sharp rate moves during the adjustment period.

 

There are Three Types of Caps

We'll list the most common adjustments according to the Consumer Finance Protection Bureau.
 
  1. Initial Adjustment Cap2% to 5%  is generally the most your rate can increase when you transition from the fixed-rate period to the adjustable-rate period.
  2. Subsequent Adjustment Cap 2% is generally the most a rate can increase after each of the adjustment periods.
  3. Lifetime Adjustment Cap – 5% generally the most that a rate can increase above your initial fixed rate for the life of the loan.
 
Knowing the caps is quite useful and can help you decide whether a variable rate mortgage is a good idea.
 
 

 

Adjustable-Rate Mortgage Advantages

 
The most significant consideration that should factor into your decision between an ARM and a fixed-rate mortgage is how long you're planning to stay in the home. We Americans move a lot in our lives. But it does seem like we're staying in our homes longer than in the past. According to the National Association of Realtors, in 2018 – Americans stayed in their homes an average of 13 years. That's an increase of three years, since 2008.
 

 

Is an ARM Mortgage Right For You?

 
In general, it's a good idea to at least consider an ARM if you are reasonably confident that you will be moving or refinancing before your loan adjusts. However, it is hard (if not impossible) to predict the future. As we all know, the economy can be unpredictable. Also, there are several requirements for obtaining refinancing. And few people know what their life will be like in five to ten years. These two issues may make this reason less compelling.
 
Another reason to consider a variable rate loan is an upcoming change in your financial circumstances. For example – changes in a career path, receiving an inheritance, or a spouse rejoining the workforce could put you in a position to afford higher payments in the future.
 
Again, we don't know our life position years down the line. If this is a consideration, it is advised that you run the numbers yourself or with a professional to determine if you could still afford the worst-case scenario payments if your assumptions about the future are wrong.
 

ARMs Are Great for the Right Borrower

 
So to our question, "Are adjustable-rate mortgages a good idea?" For those buying their starter house or have a plan to move within ten years, an ARM is an excellent choice and can save you thousands over a fixed-rate mortgage. If you are unsure, run the numbers and use a worst-case scenario. That way, you can make an informed decision.

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