- With mortgage interest rates rising every day, an adjustable rate mortgage can save you money.
- However, they are risky because your rate can skyrocket after the initial fixed-rate period.
- I recommend them if you only plan to stay in a house for a few years.
The real estate market has been red hot for the past two years, and while there are signs it might be cooling off, potential buyers now have to contend with rising mortgage rates.
Mortgage rates have skyrocketed in recent weeks: The average fixed rate on a traditional 30-year mortgage is around 5.25%, down from 3% in November and the highest since 2018.
For prospective homebuyers navigating this turbulent market, I always recommend weighing all your options, and when interest rates rise, adjustable rate mortgages (ARMs) can be more attractive.
How do adjustable rate mortgages work?
Unlike traditional (or fixed rate) mortgages, ARMs come with a variable interest rate. You’ll get an interest rate for the first few years of the loan, and then the bank will adjust the rate. Lenders offer all kinds of different ARMs with different introductory periods, from three years to 10 years (or longer!). The rate is expressed as two numbers: the first is the length of time you’ll get the fixed rate, and the second is how often your interest rate will adjust afterward.
For example, a 5/1 ARM has a fixed interest rate for the first five years of the loan, followed by a variable interest rate that adjusts each year until the loan is paid off. It could go up, down or stay the same. Your interest rate is based on general market conditions and factors determined by your lender when you applied for the loan.
All of these factors make ARMs riskier overall, which is why they typically offer lower initial interest rates than fixed-rate mortgages. According to Freddie Mac, the average initial interest rate for a 5/1 ARM is 4.12%, compared to an average interest rate of 5.23% for a 30-year fixed-rate mortgage.
For example, let’s say you’re taking out a $500,000 mortgage. If you took out a 5/1 ARM at an average interest rate of 4.12%, you would pay an average of $330 less each month than if you took out a 30-year fixed-rate mortgage at an average interest rate of 5.23%.
Why get an adjustable rate mortgage?
The biggest draw of ARMs is the lower initial interest rate. Having a lower interest rate at the beginning of the loan can help you save money than you can apply to principal, helping you pay off your mortgage faster. Because of the higher cash flow up front, you may be able to afford a more expensive house with lower payments. It can also be helpful to have extra cash flow to get an edge in the tight real estate market.
Many experts expect mortgage rates to rise even higher this year, which means it may be smart to lock in a lower interest rate now. The last thing you want is to be on the lookout for a higher mortgage rate in the future; however, ARMs may not be for everyone.
The variable nature of ARMs means you may end up paying a lot more than you initially thought. Even small changes in interest can add up to thousands of dollars in additional payments. Going back to the $500,000 mortgage example, if the interest rate goes up 2% (from 4.12% to 6.12%), the principal and interest payment increases by about $530 per month.
Who Should Consider an Adjustable Rate Mortgage?
I recommend ARM for anyone who doesn’t plan to hold the property for a long period of time, or who has the financial flexibility to weather any variable rate storm. If you’re looking for a home to stay in for just a few years, before your mortgage’s interest rate changes from fixed to variable, you may want to consider an ARM. It may be possible to refinance your mortgage before the interest rate changes, but there’s no guarantee you’ll get a better rate and you’ll have to pay
all over again.
But if you’re looking for your forever home, you may not want to take the extra risk. You’re better off choosing the financial security of a fixed-rate mortgage.
At the end of the day, the mortgage you choose should be based on your financial outlook and goals. Depending on your situation, ARMs can be a great tool to take advantage of lower rates and enjoy initial cash flow, helping you secure the right home.