As mortgage interest rates continue to edge higher, more buyers are rethinking their budgets. One option to help lower your monthly mortgage payment is an adjustable rate mortgage, but are they too risky? Here’s what you need to know about adjustable rate mortgages, according to one mortgage pro.
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What are adjustable rate mortgages and how do they work?
“ARMs — or adjustable rate mortgages — are loans with an interest rate that adjusts after a predetermined, or ‘fixed’ period of time,” explains Brian Rugg, chief credit officer for loanDepot. After the fixed period ends — usually after five, seven, or 10 years — the interest rate adjusts. This means that ARM borrowers can expect to pay a higher monthly mortgage after this initial period.
“For example, a 7/6 ARM translates to a fixed period of 7 years, with the possibility of a subsequent rate adjustment every 6 months thereafter, hence 7/6 ARM,” Rugg adds.
Are ARMs growing in popularity?
“Across the industry, we’re seeing increased interest in ARMs, which tends to happen as mortgage rates rise,” Rugg says. “ARMs generally have lower interest rates for the initial fixed period than a typical 30-year fixed rate mortgage.”
The interest rate on a 30-year fixed-rate mortgage is back to well over 5 percent after reaching record-low rates last year. As mortgage rates rise, so too does the cost of homeownership. Borrowers are now considering their options for financing to address affordability issues.
According to Rugg, data from the Mortgage Bankers Association showed that in July, the percentage of mortgage applications for ARMs was nearly 9.5 percent, compared to 3.3 percent for the same time period last year.
More borrowers are gravitating towards ARMs for a potentially lower interest rate and payment during the fixed period, says Rugg, which may increase a borrower’s purchasing power. “When determining whether an ARM is right for you, consider how long you plan on staying in the home and what your ability to repay will look like after the fixed period ends,” continues Rugg.
Rugg explains that if you plan to move before the fixed period ends, then an ARM could be beneficial to you by offering a lower rate. Similarly, if you expect your income to increase over time, then an ARM could provide a lower payment early on without negatively affecting your ability to repay after the interest rate adjusts.
Are there any risks associated with ARMs?
ARMs of today are much more heavily regulated than they were prior to the 2008 financial crisis, Rugg says. There are also other restrictions in place to prevent payment shock, such as annual and lifetime limits on rate increases and more stringent qualifying criteria.
The lifetime limit, or cap, on an ARM says how much the interest rate can increase (in total) over the life of the loan. The most common cap is 5 percent, which means that the interest rate can never be over five percentage points higher than the initial rate.
Rugg says that there’s also greater transparency when it comes to the impact of an ARM throughout the adjustment period, including the maximum interest rate and payment over the life of the loan.
“Always consider your short, medium, and long-term personal and financial goals when considering a loan program,” Rugg advises. “Any time you choose an ARM, always consider whether or not the loan will be affordable, and sustainable, in a fluctuating rate environment.”