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Homebusiness newsWith Rising Interest Rates, Do Adjustable Rate Mortgages Make Sense?

With Rising Interest Rates, Do Adjustable Rate Mortgages Make Sense?

As rates on traditional mortgages have risen, a growing number of home buyers are turning to adjustable rate loans in order to save a few dollars. But do buyers risk getting hit with significant increases when that lock expires?

Don’t let any fast-talking mortgage broker tell you otherwise: Signing up for an adjustable rate mortgage is a throw of the dice on the future of the real estate market.

But it’s a gamble that an increasing number of homebuyers are taking. Home prices may be falling, but interest rates are on the rise, which makes adjustable rate mortgages, with their initially lower rates, especially attractive.

Whether ARMs, as these typically 3, 5, or 7-year mortgages are known, are worth the risk is another matter. While they may be the right choice for some buyers, for others, rushing into an ARM could set them up for an unpleasant financial shock down the line, experts say.

How Do Adjustable Rate Mortgages Differ Other Mortgages?

Buyers who purchase a home with an ARM benefit from a lower, fixed rate for the first 3, 5, or 7 years, depending on the loan’s length. (In fact, it is often lower than what you could get on a traditional, fixed 30-year mortgage.) But once that initial period ends, the rate on the mortgage can increase, sometimes substantially if interest rates have risen during the same period.

“This is highly dependent on how long the client is planning on living in the home,” says Matthew Gaffey, senior wealth manager at Corbett Road Wealth Management in Potomac Falls, Va. “If they are fairly sure their stay in their home will be relatively short-lived, the resulting rise in their mortgage payment from a rate adjustment may be fairly irrelevant.”

Adjustable rate mortgages accounted for 10% of all mortgages issued in the U.S. in 2022, according to the Mortgage Bankers Association, which is a steep increase since the aftermath of the 2008 subprime crisis.

Why Are ARMs Popular Again?

Certainly rates are a big reason, though the cost of taking out an adjustable rate mortgage is also on the rise as well.

Rates on fixed 30-year mortgages are hovering around 6.95%, a steep increase from their August, 2016 low of 3.43%. But if you compare this with the cost of a 5-year ARM, at 5.1%, it is still cheaper than a 30-year loan.

Those lower interest costs, in turn, are proving attractive to homebuyers, especially first-timers, confronted with rising prices, especially in hot markets like Seattle, Boston, and Denver. Boston saw a 23% increase in adjustable-rate mortgage applications for first-time homebuyers in 2022 alone.

New construction that’s not keeping up with demand and a dearth of available listings has forced buyers in many markets to stretch their finances in order to buy, with ARMs a way to make their money go farther.

When Does It Make Sense to Get an ARM?

The main case for buying a house with an ARM is if you don’t plan to be living in it for years to come. Rather, you expect you will be selling in the next five to seven years because you want to move up to a larger home, or you will be moving to a new area.

In this case, the problem that comes with an ARM​​—the loss of a fixed rate and suddenly rising mortgage costs—takes care of itself. You will be rolling into a new house and a new mortgage, and at that point can plan on a 30-year fixed, or, for that matter a 15-or-20-year fixed rate loan, depending on how much equity you were able to reap from the sale of your previous home.

“You should try to match the fixed portion of your mortgage to the time you intend to live in the property,” says Eric Dostal, a vice president and certified financial planner at Sontag Advisory in New York. “If this is a starter home, a 7/1 ARM can make a lot of sense. If you are purchasing a forever home, a 30- or 15-year fixed makes more sense. It all depends on what the plan is.”

But if you are planning to stay in your house for the long-term—if this is your “forever” home—the risk you could get stuck with a bad deal when the ARM expires in five or seven years is too high, financial advisors say.

In fact, while mortgage brokers and bankers like to talk up ARMs, many financial advisors are not exactly thrilled with the idea.

David Demming, a certified financial planner and president and founder of Demming Financial Services in Aurora, Ohio, has had a mortgage license for 25 years. But he avoids ARMs, preferring instead to put clients in 10-15 year, fixed-rate mortgages.

“Adjustable rate mortgages could best be referred to as “bait and switch” because they start low and generally go higher,” Demming says. “Only a fool would take out that loan today, the exception would be a short-term owner with say a five-year rate lock.”

The Bottom Line on ARMs

The Fed’s strategy to raise interest rates to cool the inflation that ran rampant in the economy after the COVID-19 crisis doesn’t seem to be ending anytime soon, so homebuyers who don’t want to be left out in the cold may do well to consider alternative forms of financing, like adjustable-rate mortgages—just as long as they understand exactly what they’re getting into.

TheStreet, Inc. All rights reserved. Action Alerts PLUS is a registered trademark of TheStreet, Inc.

This story was originally published January 16, 2023 12:04 PM.

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