Rising rates spark renewed interest in adjustable mortgages

[UNITED STATES] In today's volatile housing market, prospective homebuyers are facing a challenging landscape of high interest rates and soaring home prices. As traditional fixed-rate mortgages become increasingly expensive, many are turning to adjustable-rate mortgages (ARMs) as a potential solution. But with interest rates on the rise, do ARMs still make sense? Let's dive deep into the world of adjustable-rate mortgages to help you make an informed decision.

Adjustable-rate mortgages are home loans with interest rates that can change over time. Unlike fixed-rate mortgages, which maintain the same interest rate throughout the life of the loan, ARMs typically offer a lower initial rate for a set period before adjusting based on market conditions.

How ARMs Work

ARMs are usually described using two numbers, such as 5/1 or 7/1. The first number represents the length of the initial fixed-rate period, while the second indicates how often the rate can adjust afterward. For example, a 5/1 ARM has a fixed rate for the first five years, then adjusts annually for the remainder of the loan term.

The Current Mortgage Landscape

As of January 2025, the average 30-year fixed-rate mortgage stands at 7.29%, a significant increase from the record lows seen in 202. This rise in rates has led to a surge in ARM applications, which now account for 7.8% of mortgage demand – the highest level of the year.

Pros of Adjustable-Rate Mortgages

Lower Initial Rates

One of the most attractive features of ARMs is their lower initial interest rates compared to fixed-rate mortgages. This can translate to significant savings in the short term and potentially allow borrowers to qualify for larger loans.

Potential for Rate Decreases

If market rates decline, ARM borrowers may benefit from lower monthly payments without the need to refinance.

Flexibility for Short-Term Homeowners

ARMs can be ideal for those who don't plan to stay in their homes long-term. If you expect to move before the initial fixed-rate period ends, you could take advantage of the lower rates without facing the risks of rate adjustments.

Cons of Adjustable-Rate Mortgages

Interest Rate Uncertainty

The primary risk of an ARM is the potential for interest rates to rise significantly, leading to higher monthly payments that may become unaffordable.

Complex Terms

ARMs often come with complex terms and conditions, including various caps and adjustment frequencies, which can be difficult for borrowers to understand fully.

Prepayment Penalties

Some ARMs may include prepayment penalties, making it costly to refinance or sell your home before a certain period.

When Do ARMs Make Sense?

Despite the risks, there are scenarios where an adjustable-rate mortgage might be a smart choice:

Short-Term Homeownership: If you're confident you'll sell or refinance before the initial fixed-rate period ends, an ARM could save you money.

Expected Income Increase: For those anticipating a significant income boost in the near future, the initial lower payments of an ARM could be manageable even if rates increase later.

Falling Rate Environment: If you believe interest rates will decrease in the future, an ARM could position you to benefit from lower rates without refinancing.

Jumbo Loans: Borrowers taking out larger loans often opt for ARMs due to the potential for substantial savings during the initial fixed-rate period.

Mitigating ARM Risks

If you're considering an ARM, there are ways to minimize the associated risks:

Understand the Terms: Familiarize yourself with the index, margin, adjustment frequency, and caps on your ARM.

Plan for Rate Increases: Ensure you can afford payments at the maximum rate allowed under your loan terms.

Consider Shorter Fixed-Rate Periods: Opting for a 5/1 ARM instead of a 7/1 or 10/1 ARM could mean a lower initial rate, reducing your risk if you plan to move or refinance soon.

Make Extra Payments: If possible, pay extra towards the principal during the initial fixed-rate period to build equity faster and potentially qualify for better refinancing terms later.

Expert Opinions

Financial experts have varying views on the wisdom of choosing an ARM in the current market. According to Joel Kan, vice president and deputy chief economist at the Mortgage Bankers Association, "Given still-high home prices and this rising rate environment, potential homebuyers are finding ways to reduce their monthly payments and view ARMs as more attractive given the widening spread between rates for ARM and fixed-rate loans".

However, Pete Boomer, head of mortgage at Regions Bank, cautions, "A borrower might perceive that the monthly savings between the ARM and fixed-rates is worth the risk of a future increase in rate". This highlights the importance of carefully weighing the potential savings against the long-term risks.

The Impact of Economic Factors

The decision to choose an ARM should also consider broader economic factors. The Federal Reserve's monetary policy, inflation rates, and global economic conditions can all influence future interest rate movements. As of January 2025, the Federal Reserve has indicated that interest rates may remain "higher for longer," which could impact the attractiveness of ARMs in the near term.

Comparing ARM and Fixed-Rate Mortgages

To illustrate the potential differences, let's consider a hypothetical scenario:

For a $400,000 home loan:

30-year fixed-rate mortgage at 7.29%: Monthly payment of $2,740

5/1 ARM at 6.33%: Initial monthly payment of $2,486

In this example, the ARM offers initial monthly savings of $254. However, it's crucial to calculate potential payments if rates increase to the maximum allowed under the loan terms.

The Resurgence of ARMs

The current interest rate environment has led to a resurgence in ARM popularity. As of May 2024, ARMs accounted for 15.5% of the dollar volume of conventional single-family mortgage originations, the highest level of the year. This trend underscores the growing appeal of ARMs as borrowers seek ways to manage high housing costs.

While adjustable-rate mortgages can offer significant initial savings and flexibility, they come with inherent risks that borrowers must carefully consider. In a rising interest rate environment, the potential for future payment increases makes ARMs a more complex choice than in periods of stable or declining rates.

Ultimately, the decision to choose an ARM should be based on your individual financial situation, future plans, and risk tolerance. It's crucial to thoroughly understand the terms of any ARM you're considering and to plan for various interest rate scenarios.

As Mike Fratantoni, MBA's Senior Vice President and Chief Economist, notes, "Inflation persists in remaining persistently high, leading markets to believe that rates, including mortgage rates, will remain elevated for an extended period. This trend poses a challenge for the housing and mortgage markets".

For those considering an ARM, it's advisable to consult with a financial advisor or mortgage professional who can provide personalized guidance based on your specific circumstances and the current market conditions. Remember, while ARMs can offer attractive initial rates, they require careful consideration and planning to ensure they align with your long-term financial goals and risk tolerance.