Buying and Selling

Adjustable-Rate Mortgages (ARMs): What They Are and When They Make Sense

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In 2005, nearly 39 percent of new mortgages were adjustable-rate mortgages (ARMs), or home loans with interest rates that are subject to change after a specified (fixed) period.1, 2 By 2016, just 2 percent of new loans were this type.3 The primary reasons for this shift are the Great Recession and the subsequent decline in interest rates. 

But now, ARMs seem to be making a comeback. In fact, ARM originations increased more than 40 percent in early 2017.4 “As housing prices continue to rise, and traditional mortgage rates creep higher, this mortgage alternative is gaining popularity,” explains Ritu Kaw, first vice president, mortgage product marketing for SunTrust Mortgage.

In this environment, it’s important for customers to recognize the tradeoffs associated with an ARM and consider any potential risk.  

ARMs and their fixed-rate counterparts

  • A fixed-rate mortgage lives up to its name: Once your rate is locked in (or “fixed”), it stays the same for the life of the term, even if that’s 30 years.
  • Adjustable rate mortgages are structured with an initial period during which interest rates are fixed—typically for five, seven or 10 years—but after that initial period ends, the interest rate is recalculated annually over the remainder of the 30-year term (or even more frequently). At each adjustment, the interest rate may go up or down. While the initial interest rates on adjustable-rate mortgages are typically lower than a fixed-rate mortgage, ARMs are much less predictable over a longer term.
    • The terms of an ARM are typically described as “5/1” or “7/1,” where the first number reflects how many years the initial interest rate is fixed, and the second indicates how frequently the rate can adjust after this period. So for example, a 5/1 ARM will have the initial interest rate locked in for the first five years, after that the rate can change each year over the life of the mortgage, which is usually 30 years.

Buyers who are worried about rising rates or who plan to be in their home for a long time may opt for a fixed-rate mortgage to essentially “lock in” their interest rate. Buyers opting for the typically lower ARM rates will need to be ready to adjust to a lower (or higher) rate, depending on the market conditions at the time of the adjustments.

Here are a few scenarios where an ARM might make sense

1. You expect your income to increase.

If you anticipate an increase in your income and want the extra breathing room in your budget during the fixed period, an ARM could give you that. “ARMs may make the most sense for borrowers who can accommodate a change in plans if they do end up with a higher rate in the long term,” says Kaw.  Stat: The millennial generation’s collective net worth is projected to grow at an annual rate of almost 15 percent, from $1.4 trillion in 2015 to $11.3 trillion in 2030.5

2. You plan to move soon.

If you plan to move before the fixed period expires, then an ARM could make sense. Keep in mind: Homeownership tenure in the U.S. has increased to 8.7 years, more than double what it was 10 years ago.More than half of millennials, however, believe they will stay in their current home for less than five years.7

3. You plan to invest the monthly savings.

If you plan to invest the monthly savings from the initial fixed-rate period of an ARM in a high-yield asset, then an ARM could work in your favor. Think hard about what you’ll realistically be able to save during the fixed-rate period and if that amount is worth potentially taking on a higher interest rate down the road.

 

Additional considerations to discuss with your potential lender are annual and lifetime limits for how high the interest rate can move. Note that some lenders may quote a lifetime cap only (instead of an annual one), which could mean a rapid increase once the fixed period concludes.

ARM Yourself with Knowledge.

Whether you’re just getting started or ready to take the next step, talk with an expert to help guide you through the home-buying process.

1 Adjustable Rate Mortgage (ARM) products have interest rates that may increase after consummation.
2 “Here’s what it would take for adjustable-rate mortgages to stage a comeback,” Jan. 1, 2016, Bankrate
3 “Home Buyer and Seller Generational Trends Report,” March 7, 2017, National Association of Realtors®
4 “Homebuyers rush to riskier mortgages as home prices heat up,” Oct. 3, 2017, CNBC
5 “The future of wealth in the United States,” Nov. 9, 2015, Deloitte Insights
6 “Real Estate’s New Normal: Homeowners Staying Put,” May 14, 2017, The New York Times
7 “Homebuyer Tenure: How Long Are People Staying In Their Houses?” March 17, 2017, The Mortgage Reports

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