More homebuyers are turning to adjustable-rate mortgages as interest rates increase and competition to buy a home remains tight. And there's a compelling reason.
The share of ARMs has been steadily climbing since the beginning of this year, as a reaction to rising rates -- in mid-January, ARMs made up just 3.1% of mortgage applications, but as of this week, this number is up to 9.4%, according to the Mortgage Bankers Association.
Currently, the average contract rate for 5/1 ARMs is 4.49% -- a full percentage point lower than a conventional 30-year fixed-rate mortgage, which is hovering around 5.5%. This means an ARM could save you thousands of dollars over the life of your loan by lowering your monthly mortgage payments and adding breathing room to your budget.
"When you're looking at a rising rate environment like this, ARMs are going to give consumers the opportunity for a little bit more purchasing power," said Brian Rugg, chief credit officer for loanDepot.
But there's a reason why ARMs have lower rates -- they can go up or down, as opposed to a fixed-rate mortgage, which locks in your rate for the duration of the loan. We'll explain what ARMs are and how to decide if this mortgage option is right for you.
What are adjustable-rate mortgages and why are they so popular right now?
While rising interest rates can make monthly mortgage payments more expensive for new homebuyers, the benefit of ARMs is that they tend to offer lower initial rates than standard 15- and 30-year fixed-rate mortgages. But there's a tradeoff.
ARMs offer a fixed rate for a shorter loan term, such as five, seven or 10 years. After this introductory period ends, your mortgage rate will adjust with the market and can change over time. For example, a 5/1 ARM will lock in your rate for five years. Once the sixth year rolls around, your lender can change your rate once per year. So, while you may lock in a rate under 4% now, it could jump back up later on.
Who are ARMs best for?
Adjustable-rate mortgages are now regulated more heavily than during the Great Recession, placing caps on how often rates can be raised and by how much. Despite increased regulation, this mortgage option still has inherent risks and may not be ideal for buyers who want flat, predictable payments or who are looking to live in a home for the duration of their mortgage.
For example, an ARM may not make sense if you're on a budget and can't afford to cover a steep increase in your monthly housing payment if interest rates rise. ARMs are also more complex to understand -- and brushing up on your loan terms and interest rate increase caps is not always as straightforward as reviewing the terms of a 30-year fixed-rate mortgage.
So when is an ARM a smart idea? This home loan option may make sense if you're buying a starter home, for example, because you don't have to worry about how much rates rising will impact you long-term if you don't plan on being in that house for decades.
"Unlike a fixed-rate product, an adjustable-rate loan may give homebuyers a lower payment during the fixed rate period, which is beneficial if they don't plan on living in the property beyond that," said Rugg.
An ARM may also make sense if you're expecting to make more money later on in your career and prefer to lock in a lower rate while you're working towards a promotion. And, if rates fall after your introductory period, you won't have to refinance to take advantage of lower rates.