Adjustable rate mortgages, known as ARMs, can be a viable option for many home buyers in 2022, however, they must consider a few things to make it the best decision
Due to Federal Reserve (Fed) rate hikes, mortgage rates have doubled in one year, from 2021 to 2022. Buying a home through a fixed-rate mortgage loan may seem crazy. For this reason, many buyers are choosing to purchase their homes through adjustable rate mortgages (ARMs).
When talking about ARMs, the ghosts of the early 2000s are present. Due to the housing bubble that led to the Great Recession in 2008, many homebuyers are not approaching lenders for these options, especially as mortgage rates have remained low.
However, due to the recent increases in interest rates by the Federal Reserve (Fed), which has impacted mortgage rates, increasing to almost 7% this year, the door is opened for the possibility of buyers buying their homes through an ARM. Why? Because adjustable-rate mortgage loans start with a low, fixed interest rate for an introductory period, usually 5, 7, or 10 years. It then begins to adjust based on market interest rates, based on a benchmark such as LIBOR or the Federal Reserve funds rate.
This increase is based on a large profit margin for the mortgage lender. Which usually means a big increase in the interest rate and your monthly payment. The most common ARM structure, a 5/1 ARM, comes with a low initial interest rate for five years, then the rate changes each year.
ARMs, regardless of their structure, typically start with an interest rate one percentage point lower than fixed mortgage rates. If we take into account that mortgages are dangerously close to 7%, we would be talking about ARMs being around 6% initially.
For this reason, home ownership is out of reach for many buyers, it is more expensive to buy a house, since a higher interest rate means a higher monthly payment. Not to mention that the price of housing remains high, despite the slight reductions in recent weeks. The central bank is confident that with the increase in interest rates, house prices will fall. It is not a guarantee.
For example, if you had a $400,000 loan, a fixed interest rate of 5.25% would guarantee you a monthly payment of $2,209 for 30 years. Instead, in a similar term with an ARM, you could have an interest rate of 4.25%, which would give a monthly payment of $1,968 dollars in the first years.
But an ARM is still a risk over the full term of the loan, because while current rates aren’t expected to stay high for long, in 30 years, anything can happen. Borrowers generally pay more money with these options throughout the life of the loan.
- You plan to pay off your loan in 5 or 10 years, to really take advantage of the benefits of a lower rate, when the fixed rate is very high as it is today.
- You plan to sell your property within 5 to 10 years, derived from the same logic as above.
If your idea is to buy a main home, an ARM can be risky and cost you more in the long run. While an ARM is tempting right now, because it has an interest rate lower than average mortgage rates, over time, they could go up and down, with no way to determine the total cost. In addition, you could incur refinancing fees and costs, which would increase the total cost of your home purchase.