Homebuyers

More Homebuyers Are Using Adjustable-Rate Mortgages. Could One Lower Your Mortgage Payment?

Homebuyers are taking another look at adjustable-rate mortgages to help them afford homeownership.

Adjustable-rate mortgages, or ARMs, made up 8.5% of all mortgage applications for the week ending Sept. 4, according to the Mortgage Bankers Association (MBA). That’s the highest share since June.

These loans can offer a lower initial mortgage rate and monthly payment for the first several years. After the introductory period ends, the rate can adjust according to the terms of the loan, subject to rate caps.

“Many homebuyers consider financing their next home with an adjustable-rate mortgage,” said Jason Gelios, a real estate specialist with Detroit’s Community Choice Realty. “I’ve had homebuyer clients choose this route due to the lower introductory rate, allowing them to gain a more attractive monthly payment and be more competitive in the market.”

The initial savings can be appealing. However, an ARM works differently than a fixed-rate mortgage. So, it’s important to understand what happens after the introductory period ends.

What is an adjustable-rate mortgage?

Unlike a fixed-rate mortgage, an ARM has an interest rate that can change over the life of the loan. Most ARMs begin with an introductory period during which the interest rate is fixed at a lower rate than many other types of loans. This period typically lasts for five, seven, or 10 years.

Then the interest rate adjusts every six to 12 months based on the current market, up to a certain limit.

“The first years of the loan are fixed at whatever that term is,” said Larry Steinway, regional sales manager and vice president of residential lending at New American Funding in Deerfield, Ill. “For example, a seven-year ARM is a 30-year mortgage where for the first seven years the interest rate cannot change.”

ARMs are available with different introductory fixed-rate periods.

What do 5/1, 5/6, and 7-year ARMs mean?

ARM names tell homebuyers how the loan works. The first number generally refers to the number of years the initial rate is fixed. The second indicates how frequently the rate can adjust afterward.

For example, a 5/1 ARM has a fixed rate for five years and can adjust once a year afterward, while a 5/6 ARM is fixed for five years and can adjust every six months.

Once adjustments begin, the new rate is typically determined by a specified index plus a lender’s margin. The rate is also subject to rate caps, so it can’t always shoot up to the current market if rates spike.

ARM vs. fixed-rate mortgage: What’s the difference?

With a fixed-rate mortgage, the interest rate remains the same for the life of the loan. That means the bulk of the mortgage payment, the principal and interest, don’t change over time.

An ARM has a fixed interest rate for an introductory period. Afterward, the rate can increase or decrease unless the borrower refinances into a fixed-rate loan.

An ARM may offer a lower initial mortgage rate and monthly payment, while a fixed-rate mortgage provides more certainty about future payments.

How much could an ARM lower the initial payment?

One of the biggest potential benefits of an ARM is a lower monthly payment during the introductory period.

For example, say a homebuyer takes out a $400,000 mortgage. If a 30-year fixed-rate mortgage were available at 6.5% and an ARM offered an initial rate of 6%, the principal and interest payment would be about $2,528 a month with the fixed-rate loan, compared with about $2,398 with the ARM.

That’s about $130 a month, or more than $1,500 over the first year.

The example is hypothetical and doesn’t include property taxes, homeowners insurance, mortgage insurance, homeowners association fees, or other costs. Actual rates, payments, and savings will vary.

What are the pros and cons of an adjustable-rate mortgage?

The biggest potential advantage of an adjustable-rate mortgage is the possibility of a lower initial interest rate and monthly payment. The primary risk is that the rate and payment may increase after the fixed-rate period ends.

An ARM may be worth considering for homebuyers who don’t expect to keep the mortgage for beyond its initial fixed-rate period.

“Someone might take [a 7/1 ARM] if they are planning on selling the home within seven years, paying off the home within seven years, or if they anticipate that rates will come down within that seven-year period and they will have an opportunity to refinance to a lower rate,” said Steinway.

Buyers should note that future mortgage rates are difficult to predict.

How much can an ARM rate change?

ARMs typically include caps that limit how much the rate can change.

An initial adjustment cap limits the first change after the fixed period. A subsequent adjustment cap limits later changes, while a lifetime cap limits how much the rate can change over the life of the mortgage.

How high can an ARM rate go? That depends on the loan’s specific rate caps. Homebuyers should review the maximum interest rate and highest possible monthly payment before choosing an ARM.

The rate does not automatically increase when the introductory period ends. Depending on the loan terms and relevant index, it may rise or fall.

Is an adjustable-rate mortgage right for you?

Whether an adjustable-rate mortgage is a good fit depends on a homebuyer’s finances, plans for the home, and comfort with the possibility that the interest rate and monthly mortgage payment could change.

Find out how long the initial rate is fixed, when the first adjustment occurs, how often the rate can change afterward, and the initial, subsequent, and lifetime rate caps.

It’s also worth finding out the highest possible monthly payment. The Consumer Financial Protection Bureau recommends understanding that number even if a homebuyer expects to sell or refinance before the adjustable period begins.

For some homebuyers, an ARM’s lower initial rate could make the monthly payment more manageable. Understanding what could happen to the rate and payment later is just as important as knowing what the mortgage costs today.

Larry Steinway NMLS #223579