Rising interest rates are causing many home buyers to consider adjustable-rate mortgages (ARMs) after a long period in which ARMs were out of favor. Interest rates on 30-year fixed-rate mortgages topped 4.1% in late-January, on average, while rates on five-year ARMs were around 3.5%.
ARMs can entice borrowers with their lower initial interest rates. But borrowers should carefully consider the likelihood that the rates will jump in later years. In addition, ARMs are more complicated than their fixed-rate counterparts, with many variations on when and by how much rates may rise. Consider these factors when deciding whether an ARM is right for you…
Types of ARMs
ARMs can take many forms, though they generally include a fixed-rate period followed by regular interest-rate adjustments. The details of this arrangement typically are represented by two numbers used in the description of the ARM. The first represents the initial length of time during which the rate doesn’t change, and the second represents how often the interest rate adjusts after that period ends. For example, a one-year ARM, or 1/1 ARM, adjusts its interest rate every year. A hybrid ARM has a longer fixed period. For example, a 5/1 ARM has a fixed rate for five years before adjusting annually.
ARMs vary in other ways as well. The interest rate is adjusted based on the movement of a specific index—such as the London Interbank Offered Rate (LIBOR) or the yield on Constant Maturity of Treasury securities adjusted to one year (CMT)—and an additional margin that is added to the calculated index rate. For example, if the index hits 3% in a given year and your margin is 2%, your rate will be 5%. When interest rates rise, so do the indexes, and the interest rate you pay on your ARM will rise in turn. Conversely, when interest rates fall, your interest rate will fall as well.
The choice of index that an ARM tracks can have an impact on your loan due to differences in how indexes typically move in response to changing economic conditions. For example, the CMT is based on average Treasury yields. Because the index value is calculated as an average, CMT rates tend to move in a more measured way, which could be beneficial for borrowers when interest rates are rising. In exchange for this benefit, though, banks typically charge a higher margin on ARMs tied to the CMT. That compares to so-called “spot rate” indexes like the LIBOR, which is based on the interest rate London banks pay when they borrow from one another. Since LIBOR may use one specific point in time rather than an average and tends to follow central bank policy movements, it can rise or fall more rapidly, which can be beneficial in a falling interest rate environment but potentially costly when rates are rising. However, banks typically charge a lower margin on ARMs tied to LIBOR.
When shopping for an ARM, ask lenders which indexes their loans track and how large the margin is. ARMs also have caps that control how high the interest rate on your loan can rise at each rate change and over the life of the loan, so ask potential lenders about these rate limits.
Your Time Frame
When choosing between a fixed-rate mortgage and an ARM, consider how long you plan to stay in your home before you sell it. If you plan on being there over the long term, a fixed-rate mortgage with a predictable interest rate may make more sense. However, if you plan to sell your house within a few years—for example, if you have a growing family and may need a bigger house soon, or you plan to retire in the next five years and will want to downsize—an ARM can be beneficial if interest rates are low during the fixed-rate period. Consider a hybrid ARM, such as a 5/1 ARM, that offers a low fixed rate for five years before the rate adjusts. If you sell within the five-year fixed-rate period, you can avoid the risk that your interest rate will rise beyond what your budget can bear.
Important: The longer the fixed period is, the less of an interest rate discount you will receive compared with a fixed-rate mortgage. Example: Where a 5/1 ARM may offer a 0.75% discount compared with a 30-year fixed-rate mortgage, a 10/1 ARM might offer only a 0.25% discount.
Are Rates Likely to Rise?
In general, ARMs tend to make the most sense for home buyers when market interest rates are high because locking in a high interest rate with a 30-year mortgage is not an attractive proposition. Additionally, interest rates tend to be cyclical, and with an ARM, they may fall by the time your mortgage adjusts for the first time. Of course, you can refinance a fixed-rate mortgage if market rates drop, but there are costs associated with refinancing—while there are no costs to you when an ARM rate drops automatically after market rates drop.
What about the current market? Interest rates have been low for a decade and are likely to rise to some degree, though it’s unclear how large future rate hikes will be. To make sure you can afford to take on an ARM in a rising-rate environment, model your potential future payments with an online amortization calculator such as the one on my site, HSH.com/mortgage-calculator.html. This tool can show you what your costs for an ARM’s fixed period will be compared with a fixed-rate mortgage and let you see potential future payments for the adjustable period based on different future interest rate changes. Run a best-case scenario in which interest rates fall…and a number of worst-case scenarios in which interest rates rise dramatically. This way, you can assess how using an ARM might affect your finances down the road.
Hedge Your Bets
If you do take out an ARM and later become worried about its financial impact in a rising interest rate environment, you can decide to protect yourself by refinancing your loan. Bear in mind that refinancing can be pricey, typically costing several thousand dollars.
You can also hedge your bets by taking the money that you save during the fixed period of an ARM and putting it in a savings account. If at the end of your fixed period your interest rate moves higher than expected, you will have a cash cushion to help make up the difference.