High Interest Rates Are Driving Interest in ARMs
With fixed-rate mortgages hovering near the 7% mark, we are fielding more questions from clients about a popular alternative: the Adjustable-Rate Mortgage (ARM).
An ARM provides an initial interest rate that is typically lower than a traditional fixed-rate mortgage, but that rate adjusts after an introductory period. Since 2021, the share of newly originated ARMs has increased tenfold, recently making up about 8.5% of all new mortgages.
The Appeal: Lower Initial Monthly Payments
The benefit of an ARM is clear, where a lower initial interest rate means a significantly lower monthly payment. If you plan to move or sell the home before that initial fixed period expires (often 5, 7, or 10 years), an ARM can be a strategic way to lock in savings with minimal risk.
The Risks: Market Fluctuations and Rate Adjustments
However, as many homeowners learned during the 2008 financial crisis, ARMs carry inherent risks. Once the introductory period ends, your rate adjusts based on current market interest rates. If rates have climbed significantly, you could face a major “payment shock” when your monthly bill resets.
When the reset happens, your lender recalculates (or re-amortizes) your monthly payment using the new, higher interest rate applied to your remaining principal over the time left on the loan. For example, on a 7-year ARM, your new payment in Year 8 will be recalculated across the remaining 23 years. If interest rates are significantly higher at that time, that recalculated monthly bill can jump substantially.
Refinancing Isn’t Always Guaranteed
Many borrowers take out an ARM assuming they will simply refinance into a fixed-rate loan before the rate adjusts. While this sounds great in theory, it’s not always guaranteed in practice.
If your home’s value decreases or your financial situation changes, you might not qualify for a refinance. Even if you do qualify, you may still be responsible for new closing costs.
5 Key Questions to Ask Before Choosing an ARM
If you are considering an ARM, it is crucial to read the fine print. Make sure you answer these five questions:
- Does the mortgage payment include both principal and interest, or is it interest-only?(With an interest-only loan, your required payments may not reduce the amount you owe during the interest-only period, and your payment could increase significantly when principal payments begin.)
- How often can the interest rate adjust after the initial fixed-rate period ends?
(For example, every six months or once per year?) - What index is the ARM tied to, and what is the loan’s margin?
(For example, will it adjust annually or every six months after the initial period ends?) - What are the interest-rate caps?
(Rate caps limit how much your interest rate can increase at the first adjustment, at each subsequent adjustment, and over the life of the loan. Understanding these limits can help determine your potential maximum payment.) - Is there a prepayment penalty? (Some loans may charge a fee if you pay off the mortgage early, including when you sell your home or refinance. Make sure you will understand whether a penalty applies and how long it remains in effect.)
Finding the Right Fit for Your Strategy
While economists do not expect a repeat of the 2008 housing crisis, it is always important to carefully weigh the trade-offs between a fixed-rate and an adjustable-rate mortgage.
If you have questions about how a specific mortgage strategy fits into your long-term financial plan, let’s talk!
You can schedule a strategy session to talk about your unique situation and how we might be able to help. If you are a current client, contact us for a personal review of your situation at info@astifinancial.com.