Should you consider an adjustable rate mortgage with rising rates?
Kristin McKenna, Darrow Wealth Management, YCharts
Interest rates are rising, and that’s bad news for homebuyers. The national average rate for a 30-year fixed mortgage is now above 5%. After being in the 2% range for much of the Covid era, buyers are now facing a blow: a burning housing market and rapidly rising rate. For some buyers, it may make sense to consider an adjustable rate mortgage (ARM) instead of a fixed loan.
Characteristics of an adjustable rate mortgage
As the name suggests, when you get an adjustable rate mortgage, you don’t have a fixed interest rate for the term of the loan. Instead, the interest rate is only fixed for a certain number of years before changing to a variable rate. For example, a 7/1 ARM is fixed for seven years, before changing to a variable rate that adjusts once a year.
When considering a variable rate mortgage, it is essential to understand the terms of the variable portion of the loan. Some key questions to ask include: how much can the initial variable rate exceed the fixed rate, annual increase limits, lifetime rate caps and floors. Ask what index is used to determine the base rate and what your margin will be. Do some research to get an idea of how rates change over time.
Why consider an ARM?
Getting an adjustable rate mortgage makes the most sense in situations where there is a big spread between fixed and variable mortgage rates. and an expectation that at least one of the following will occur during your term:
- You sell the property
- Interest rates will drop, giving you the option to refinance into a fixed rate mortgage
- Your price caps are manageable and you can still afford to buy the house during the variable period, assuming the worst case scenario
Interest rate spreads
For comparison, look at the difference between the average 5/1 ARM mortgage rate and a traditional fixed rate (chart above). The difference is greater than 1.3%. On a hypothetical $1 million loan, the adjustable rate could save almost $10,000/year during fixed years.
Note that the rate you may qualify for will depend on your credit, purchase price, location, down payment and loan terms. The fixed rate period is an essential part of this equation. For example, Zillow estimates that the national average ARM 7/1 rate is currently 4.82% on a conforming loan.
When rates are low or the spread is low, adjustable rate loans usually don’t make sense. It’s often best to lock down the safe thing – even if you end up moving in a few years, it’s essentially a free option. Especially if it is possible to keep the property as a rental, as investor loans are not as favorable and usually require equity or additional funds.
But again, factors unique to your situation and your purchase affect the outcome. For example, Zillow reports that the average rate on a 7/1 ARM for a jumbo loan is just over 4%, more than 1% lower than the 30-year fixed rate. Compliant loans are mortgages below $647,200 for most of the United States
Risks
An ARM makes it more affordable to buy more homes. Maybe that’s not a good thing. It is important to assess your means and not to extend too much. Also, remember that you can’t control the direction interest rates take. Being able to refinance during the fixed period is not guaranteed like a fixed rate mortgage. Always be sure to consider the possibility that you want to stay in the house when the loan is variable. Can you afford it?
Fixed-rate or adjustable-rate mortgage loan: the essentials
Before making a financial decision, you should always consider your options. For many Americans, a home is their greatest asset and a major purchase, so it’s prudent to research the pros and cons of your financing options, including whether to buy with cash or with a mortgage. And don’t be afraid to shop! It is usually advantageous to speak with a range of lenders from a local regional bank to a national mortgage broker. Even for the same loan product, quotes can vary significantly.
There are a lot of other things to consider when getting a mortgage, but the bottom line for fixed or variable rate mortgages is this: when rates go up, it’s definitely worth it. to consider an MRA.