Variable rate mortgages are growing in popularity. Do they suit you?
Demand for adjustable rate mortgages (ARMs) all but disappeared from the home lending landscape after the 2008 financial crisis, until recently. With the Fed’s interest rate hikes, including another hike last Wednesday, buyers are once again turning their attention to ARMs.
Conventional fixed-rate mortgages are still leading the way, but ARMs have gained momentum in response to mortgage rates continuing to rise in 2022 to their highest levels since 2008, according to the Mortgage Bankers Association.
Although the volume and public perception of MRAs has declined due to their contributions to the financial crisis of the 2000sthey are now more tightly regulated and provide an affordable route to home ownership for many.
Simply put, an ARM is a home loan with an interest rate that will change over time. ARM rates can go up or down, usually depending on the economy.
Hybrid ARMs are the most common. They have lower initial rates that are fixed for a fixed term – usually for three, five, seven or 10 years – before switching to a variable rate. The variable rate is adjusted according to variations in the rate index to which it is linked, such as the monthly Treasury average.
There are also two other types of ARM:
• Interest only ARM allow buyers to pay only the interest due on the loan for a specified period of time before they also have to start paying the principal.
• ARM with payment option let buyers choose how to make their monthly payment. Buyers can opt for a combination of interest plus principal, interest only, or a low minimum payment that meets the basic loan requirements without necessarily reducing the balance.
ARMs can help some buyers weather rising interest rates with savings early in their tenure. This can lower upfront costs when homebuyers’ money is tight, get homebuyers into the market sooner, or make buying a home cheaper in the short term than with a fixed-rate mortgage.
To find out if an ARM might be right for you, here are some helpful questions to ask your lender:
What is the margin on the loan? Your lender can influence your rate by adding a few percentage points. This is called the margin and it generally remains constant throughout the loan. A similar question to ask is what is the annual percentage rate (APR) of the loan.
What are the ceiling rates? Although you should be prepared for the possibility of higher monthly payments in the future, the rate increases are not endless. ARMs have several types of rate caps:
• Periodic adjustment caps set a cap on how much your rate changes between adjustment periods, including the initial adjustment after the fixed rate expires
• The limit of the lifetime caps increases during the term of the loan
• Payment caps limit how much the monthly payment can increase with each adjustment.
Does the loan have a floor rate? Some ARMs have a minimum rate, called a floor ratethat the rate will not be adjusted below.
Based on these answers, you will also need to ask yourself a few questions:
Do I have enough money to cover worst-case rate increases? Review your budget and price caps. Do the calculation based on your current income. Any projections of future earnings should be taken lightly until they are guaranteed. If you have or plan to incur additional debt, such as tuition fees, make sure you can afford to pay those fees as well.
How much will an ARM cost compared to a fixed rate mortgage? Ask for quotes for a fixed rate mortgage and an ARM. Then compare monthly payments, upfront savings, and other details to determine what’s right for you over the life of the loan.
MRAs aren’t a shortcut to buying a house you can’t afford. Just like with a fixed rate mortgage, buyers should review their financial and life plans to make sure they are both ready to apply for and afford an ARM.
Your monthly payments will eventually change whether you choose a fixed or adjustable rate mortgage, as insurance premiums and property taxes may change. Everyone’s planning and circumstances are different, but the bottom line is that mortgage payments will stay smooth for the life of the loan, whether you opt for a fixed rate or an adjustable rate.
Damien Manno is Associate Vice President of Home Lending for Ardent Credit Union.