Do Adjustable-Rate Mortgages Make Sense In a Hot Housing Market?
Turning to Adjustable Rates
Demand for mortgages is plummeting, as the Mortgage Bankers Association reported total mortgage application volume fell 8.3% last week, compared to seven days prior. Going back a full calendar year, applications were down by half.
Analysts say this is due to rising mortgage rates, as the average 30-year fixed-rate mortgage stands at 5.37%, the highest it’s been since 2009. During the same week in 2021, the average rate was 3.17%. In response, homebuyers are increasingly turning to adjustable-rate mortgages, or ARMs. The ARM share of applications checked in at 9% last week, double what it was in January.
What is an ARM?
The best way to understand adjustable-rate mortgages is by comparing them to fixed-rate loans. When you finance the purchase of property with a fixed-rate mortgage, the interest rate doesn’t change over the life of the loan. By definition, the interest rate fluctuates over time for ARMs.
Sometimes called floating or variable-rate mortgages, the rate for an ARM is periodically reset based on an index or standard benchmark. Often the rate initially agreed upon remains constant for five years, after which it adjusts annually usually as a premium added to a reference rate such as SOFR, the Secured Overnight Financing Rate.
How Buyers Should Prepare
The average rate on a five-year ARM checked in at 4.28% last week, a full percentage point lower than the average 30-year fixed-rate, so it’s not hard to see why they’d be popular. Still, advisors note it’s important to consider the potential downside as well.
Borrowers are typically cautioned they should envision a potential “worst case” scenario before signing on for an ARM. Rather than imagining a 1% or 2% increase after the loan’s initial period, consider the possibility of the rate rising by 3% or 4%. It may seriously impact a borrower’s ability to cover the monthly payments. Also note that some ARMs set a maximum amount for the initial increase, and there can be a lifetime adjustment cap as well.
If you’re seriously considering an adjustable-rate mortgage, it is highly recommended that you know all the facts before making a commitment. What’s the limit on how high/low the rate can go, and how often will the rate change?
If your rate reaches the maximum, would you still be able to afford to make payments? When rates change, how quickly will that affect your monthly payment? Calculate all these contingencies with your potential lender.
Each lender is different, so don’t make any assumptions about how your adjustable-rate mortgage will play out. After learning the loan details, you may decide that an ARM is right for you. If you aren’t comfortable with the terms, you might opt for a fixed rate.
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