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Homebuyers today face a triple threat of record housing prices, low inventory, and mortgage rates that remain stubbornly high, a combination that makes the dream of homeownership more costly than ever.
It’s no wonder, then, that those taking on new home loans are looking for ways to lower their monthly payment. For some, that includes an adjustable-rate mortgage (ARM).
Research by data analytics company CoreLogic found that the share of ARM loans in dollar volume relative to fixed-rate mortgage loan originations has fluctuated from roughly 4 percent to 25 percent since 2009 — coming in at nearly 16 percent of the dollar volume of conventional single-family mortgage originations in May 2024.1
The logic of choosing an ARM in a high interest rate environment isn’t flawed, said Armando Sallavanti, a CERTIFIED FINANCIAL PLANNER® professional with MassMutual Greater Philadelphia.
After all, many current homebuyers expect (and hope) to refinance their mortgage loan anyway over the next few years when interest rates are projected to fall. By choosing an ARM, which offers a lower initial interest rate than a fixed-rate mortgage, they can potentially lower their monthly bill over the short term until rates fall enough to refinance.
“ARMs offer lower initial interest rates compared with fixed-rate mortgages, meaning smaller monthly payments in the early years,” said Sallavanti. “There are also potential savings if interest rates decline — because an ARM could adjust lower — or if you plan to sell or refinance before the rate adjusts.” (Related: How to make a down payment on a house: Do's and don'ts)
ARM risks
But there are also some very real risks to consider when choosing an adjustable-rate mortgage, ones that could put homebuyers in jeopardy of losing their home.
For example, if mortgage rates should climb after the initial fixed-rate period expires, borrowers could face significantly higher payments. And if rates were to continue to rise, your payments could become unaffordable, making it difficult or impossible to meet your debt obligations.
The uncertainty of fluctuating mortgage payments with an ARM could also make it harder to stick with a budget and save for future goals. Many financial professionals recommend consumers spend no more than 30 percent of their gross monthly income on housing.
If you’re considering an adjustable-rate mortgage, it is important that you understand how they work, the benefits and risks, and the terms of your specific loan, which can greatly affect future affordability. (Related: Owning vs. renting)
How do ARMs work?
As the name implies, adjustable-rate mortgages typically offer a lower initial interest rate (sometimes called a “teaser” rate) than a traditional fixed-rate mortgage — often 0.5 percent or more lower. On an $800,000 loan, the savings you might generate by opting for a 6.2 percent ARM versus a 7 percent fixed-rate mortgage would amount to roughly $423 a month, according to Bankrate’s mortgage calculator.
“This initial floating rate can often provide savings to a new homeowner who is unsure about their long-term plans and is not looking to commit to a lengthy fixed-rate loan,” said Daniel Drabinski, founder of Integrated Strategies financial services firm in Dallas, Texas.
Hybrid ARMs, the most popular ARM products, offer a combination of fixed and variable interest rates. After the initial fixed-rate period, which is typically three, five, seven, or 10 years, the interest rate on an ARM can adjust higher or lower based on prevailing market conditions.
For example, a 5/1 ARM means that the interest rate will remain fixed for the first five years, and that it can adjust once a year thereafter. Other ARMs are set to adjust every six months after the initial fixed-rate period expires.
Many ARM products also come with an annual cap and/or a lifetime cap, which limits how much the interest rate can climb during each adjustment period and over the life of the loan, which provides some protection for borrowers in the event that interest rates should climb sharply. Before you sign on the dotted line, it is critical that you understand the maximum amount your interest rate can climb.
Be aware, too, that some ARMs charge fees or penalties for paying off your loan early, especially during the initial fixed-rate period.2
As you research ARM loans and comparison shop, be particularly mindful of the repayment plans.
Previously popular loan products, such as interest-only ARMs and payment-option ARMs, which enabled homeowners to choose a monthly payment that could be less than the interest owed, made ARMs a riskier proposition for consumers.
By paying only the interest on their loan (and nothing toward their principal), the borrower with an interest-only ARM never reduced their loan balance. Worse, those who paid less than the monthly interest owed under a payment-option ARM actually increased their loan balance as the unpaid interest got added to their mortgage, forcing them to pay interest on their interest — a repayment structure known as negative amortization.
In the wake of the 2008 housing crisis, however, the Consumer Financial Protection Bureau enacted its Qualified Mortgage standards for residential loans, which prohibits lenders from offering mortgages with harmful features like negative amortization. But interest-only ARMs still exist and, in limited cases, may still serve a purpose.
“The risk of this strategy is the inevitable long-term cost,” said Drabinski. “The longer the interest-only period, the larger the eventual payment of principal.”
The onus is on homebuyers to research loan terms carefully, so they do not get in over their head.
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When might an ARM make sense?
According to Sallavanti, an ARM might be ideal for:
- Those who plan to refinance before the initial fixed-rate period expires.
- Homeowners with a shorter-term time horizon, who expect to sell their property in five to seven years.
- Borrowers with a stable income who know they can afford their mortgage payments if their interest rate adjusts higher.
- Those who prioritize lower monthly payments initially to leave more money available for other investments or wealth-building opportunities.
When to refinance your loan
If your plan involves refinancing from an ARM to a fixed-rate loan when (and if) interest rates drop, you should plan for the costs involved.
The average cost of a refi, which includes a new appraisal, origination documents, and application fees, is typically from 2 percent to 5 percent of the loan amount.
For that reason, many financial professionals suggest homeowners only consider a refi if they can reduce their interest rate by 2 percent or more. Those with jumbo mortgages, however, may find that it makes financial sense to refi after rates have fallen by at least 1 percent. (Learn more: How to refinance your mortgage)
Drabinski said homebuyers should answer these four questions when making a decision regarding whether to select an ARM or a fixed-rate mortgage:
- How long do you plan to remain in the home?
- What will your initial monthly payment will be?
- What is the break-even point where the savings you would generate by refinancing to a fixed-rate loan would offset the cost of the refinancing itself?
- How much interest rate risk are you comfortable taking on?
Alternatives that may help lower your monthly payments
Apart from an ARM, there are other routes you can potentially take to reduce your monthly housing costs. For example, you can come to the closing table with a down payment of at least 20 percent of the purchase price. (Related: Getting money for a house down payment)
Doing so enables you to eliminate the fee for private mortgage insurance (PMI), which lenders assess to protect themselves in the event that you should default on your loan. PMI is typically from 0.5 percent to 1.5 percent of the loan amount per year, with the lower range reserved for borrowers with a higher credit score.
You may also be able to buy down points, sometimes called “discount points,” in which you pay more upfront at the closing in exchange for a lower interest rate on a fixed-rate mortgage. (Learn more: Buying your first home)
Each point can lower your interest rate by roughly 0.25 percent, but it will cost roughly 1 percent of your mortgage amount. For example, on a $500,000 loan, each discount point would cost $5,000.
To reduce your mortgage rate by 1 percent, which could lower your monthly payment substantially, you would need to buy four discount points ($20,000 for a $500,000 loan).
But the math must make sense. Because of the costs involved, buying down points is best reserved for homebuyers who plan to stay put long-term. Here again, to make an informed decision, you should determine what your break-even point would be.
Conclusion
Homebuyers who are shopping for loans when prevailing interest rates are high could save money by opting for an adjustable-rate mortgage with a lower initial interest rate.
But such mortgage products do involve greater risk.
When determining the right loan terms for you, consider your financial needs, appetite for budget uncertainty, and alternatives that could help lower your monthly mortgage payment using a fixed-rate loan.
Discover more from MassMutual…
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1 CoreLogic, “Adjustable-Rate Mortgages Gain Popularity Amid Surging Rates,” July 23, 2024.
2 Freddie Mac, ”Considering an Adjustable-Rate Mortgage? Here’s What You Should Know,” Jan. 2, 2024.
