Adjustable Rate Mortgage (ARM): Pros and Cons in Today’s Environment

With mortgage rates trending up and home prices still climbing, more borrowers are looking to adjustable-rate mortgages (ARMs). Why? Because this type of mortgage can be a more affordable option for buying your home, especially as higher rates on fixed mortgages begin to price some borrowers out of the market.  But, is it worth the risk? ARMs come with lower fixed interest rates for an initial period, after which the rate moves up or down at regular intervals for the remainder of the loan’s term.  

At the beginning of 2002, very few borrowers were bothering with ARMs. In fact, they accounted for just 3.1% of all mortgage applications, according to the Mortgage Bankers Association (MBA). Fast forward to September 2022, and that figure has tripled to more than 9%.  The surge is directly related to the rise in fixed mortgage rates, which have rapidly increased by more than 6% points – a range not seen since 2008. Higher fixed rates translate into lower purchasing power, so the lower introductory rates attached to ARMs have begun to look much more appealing. 

Is an ARM Right For Your Situation?

A lower monthly mortgage payment sounds like a no-brainer. However, ARMs carry some risk and they’re not a fit for every borrower. Weighing the pros and cons is important. Here are a few key signals that an ARM might be right for your situation.

You’re not buying your forever home. ARMs typically have fixed-rate introductory periods of three, five, seven or 10 years. So, they can make sense for a borrower with plans for a shorter time frame in their new home and where they are likely to sell their home before their rate adjusts. 

You’re comfortable with the risk. If you’re set on buying a home now with a lower payment to start, you might simply be willing to accept the risk that your rate and payments could increase, regardless of whether or not you plan to move. Some borrowers perceive that the monthly savings with an ARM vs a fixed-rate mortgage is worth the risk of a future increase in rate. 

You’re borrowing a jumbo loan. Many borrowers taking out bigger loans opt for an ARM. As of March 2022, nearly 40% of originations were above $1 million, according to CoreLogic.

You’re able to make extra payments in the introductory period. If there’s room in your budget to pay extra toward the loan principal during the initial rate period, a lower-rate ARM can help maximize those interest savings. You will want to weigh the different scenarios with your mortgage broker. 

Know the Risks

While ARMs have definitely staged a comeback in today’s rising rate environment, it can be more difficult to qualify for one compared to a fixed-rate mortgage. This is because you’ll need a higher down payment of at least 5%, versus 3% for a conventional fixed-rate loan. There’s also a need to verify that your current financial situation will allow for a higher payment in the future – even if you plan to move before the lower-rate period ends.  Most ARM loans are now underwritten based on the highest payment expected on the loan to ensure the borrower can handle payment after a rate increase. 

It’s impossible to predict the future which underscores the primary risk with ARMs. What if you’re nearing the end of the introductory period and lose your job? What if your plan to sell the home gets derailed by a market downturn? Nothing in life is certain, so if you need a stable monthly payment – or simply can’t tolerate any level of risk – it’s best to go with a fixed-rate mortgage, despite the expense. 

As a general rule, the shorter the introductory period, the more competitive the interest rate.  Additionally, most ARMs have caps on how much the rate can increase at each interval after the introductory period, along with a lifetime cap that limits the amount it can increase throughout the loan’s term. 

In Summary

Although ARMs are popular again, the risks haven’t changed. Overall, this type of loan is better for borrowers who plan to sell their home ahead of the first rate adjustment and who can afford the highest potential monthly payment. If you’re still living in the home once the variable-rate period commences, be ready to regularly  reevaluate your budget as your payments ebb and flow with each adjustment.