With home prices soaring in 2021 and interest rates climbing in 2022, many prospective homebuyers are considering alternatives to the traditional fixed-rate mortgage. Although adjustable-rate mortgages are a popular option with real upsides, borrowers should also be aware of potentially significant risks.
What Is An Adjustable-Rate Mortgage?
Adjustable-rate mortgages are often abbreviated as ARMs, and are sometimes also called “variable-rate mortgages” or “floating-rate mortgages.” ARMs offer interest rates that are initially low compared to traditional fixed-rate mortgages. After the introductory period, the ARM’s interest rate varies. (To compare ARMs to other types of mortgages, see our colleague Eric Meermann’s article “Buying Your First Home: Down Payments And Mortgages.”)
One of the most common types of ARM is a “hybrid ARM.” Depending on the loan terms negotiated with the lender, the ARM’s rate is fixed for a period of 10 years or less; this is sometimes called the teaser period. An ARM’s initial interest rate is set below prevailing market rates, making it an especially attractive option in a high interest rate environment.
Succeeding the teaser period is the adjustment period. Depending on the type of ARM, the variable interest rate can change every month, quarter, year or few years. Lenders usually base the adjustable rate on one of a few standard indexes: Constant Maturity Treasury Index (CMT), the Cost of Funds Index (COFI), or the Secured Overnight Financing Rate (SOFR). On top of the adjustable base interest rate, lenders also add on percentage points, commonly referred to as “margin.” The better a borrower’s credit score, the lower the margin in most cases. Together, the index-based rate and the margin are known as the mortgage’s “fully indexed rate.”
When shopping for an adjustable-rate mortgage, you will usually see it described with a combination of two numbers. The first number represents the number of years that the interest rate will remain fixed. The second number can denote either the loan’s duration or how frequently the interest rate will change after the teaser period. For example, a 2/28 ARM has a fixed rate of two years and a variable rate of 28 years. In contrast, a 10/1 ARM has a fixed rate for the first ten years and adjusts annually after that. Though there are many different types of ARMs, the most common are a 5/1 ARM and 10/1 ARM.
Adjustable-rate mortgages can also include interest rate caps and floors, which respectively limit the increase and decrease of a loan’s interest rate. An ARM with a set maximum and minimum for the adjustable interest rate can help borrowers avoid extremely high and low payments. A loan with interest rate caps typically has three specific and distinct types: an initial cap, a periodic adjustment cap, and a lifetime cap. You will often see these three caps expressed as a three-number sequence in the description of the ARM. The first number indicates a limit on the initial adjustment to the loan’s interest rate. The second describes the limit on each successive adjustment, and the third relates to a limit on the total change in interest rate over the loan’s lifetime.
All of these specifics can seem intimidating to some borrowers, but they offer useful information when you break them down. Let’s consider a 5/1 ARM with a 5/2/5 cap structure. The initial interest rate remains fixed for the first five years of the loan, then adjusts annually for the remaining 25 years — thus “5/1.” The second set of numbers relates to an interest rate cap. After the expiration of the fixed rate, the loan’s interest rate cannot increase more than 5% the first time it adjusts. During the successive years, the rate can adjust up to 2% at each adjustment, but the overall change in interest rate should not exceed more than 5% over the loan’s life.
Be aware that various subtypes of ARMs fall under the umbrella term. In addition to hybrid ARMs, types include interest-only ARMs, payment-option ARMs, interest-only payment ARMs, and minimum or limited payment ARMs. The full details of these different types is beyond the scope of this article, though it is important to fully understand any mortgage you’re considering. When not otherwise specified, we are discussing hybrid ARMs throughout this article. When considering an ARM, it is important to understand exactly which type of mortgage you are getting and the specifics of its duration, adjustment period, and any caps or floors on the interest rate.
Benefits And Pitfalls Of ARMs
Housing affordability has hit a marked low in the last three decades, especially with interest rates on the rise. As of this writing, the national average rate on a 30-year fixed mortgage is 7.32%, and the Federal Reserve is expected to raise rates again before the end of 2022. Making matters worse, housing inventory is low, further driving up prices. Under these circumstances, opting for an ARM as opposed to a fixed-rate mortgage holds an obvious appeal, given the initial rates well below those available on fixed-rate mortgages. According to the Mortgage Bankers Association, as reported by The Wall Street Journal, as of August 2022 more than 9% of all mortgage applications were for ARMs, compared to 3.3% in August 2021.
On the other hand, overestimating how much house you can actually afford could leave you homeless in a worst-case scenario. With an initial fixed interest rate significantly lower than prevailing market rates, in a short-term perspective, an ARM can seem like the best option. When the adjustment period begins, however, borrowers face higher risk, since rates are not guaranteed apart from the bounds of interest rate caps and floors. Borrowers who are unable to afford the potentially high monthly payments in the adjustment period may experience financial hardship, or even foreclosure.
In addition to these inherent dangers, borrowers should be especially cautious of lenders offering an initial rate below the loan’s fully indexed rate. This approach, known as offering a discounted rate, allows lenders to make ARMs even more attractive. But accepting such offers can set borrowers up for payment shock in the future. In many cases, the difference between the discounted rate and the fully indexed rate is added to the loan’s principal balance. This practice, known as negative amortization, can lead to burdensome monthly payments, especially in combination with an adjustable interest rate.
Despite these pitfalls, there are some legitimate and sensible reasons to select an ARM. Anticipated increases in income within the next few years may encourage borrowers to opt for an ARM to take advantage of the lower rate in the meantime. For example, a homebuyer who anticipates a pay raise in the near future may opt for an adjustable-rate mortgage in anticipation that, by the time the higher rates arrive, the borrower will have a correspondingly higher income. That said, future income is rarely guaranteed, and borrowers should remain aware that they are responsible for mortgage payments even if the promised promotion does not appear.
Another common reason to choose an ARM is a situation where a buyer plans to sell the home within the fixed-rate period. These buyers may not be ready to purchase their “forever home” for a variety of reasons. Say a couple in their mid-20s decides to purchase a home. While they have no children, they plan to try to have a baby within the next five years. The couple secures a 5/1 ARM and purchases a house that is a perfect size for the two of them, but too small for their planned future family. Since they plan to move within the next five years, during which the interest rate is fixed, they will pay less monthly interest compared to a fixed-rate mortgage.
Even if they don’t plan to move, some borrowers might anticipate either fully paying off the mortgage during the teaser period, or refinancing before the adjustment period begins. A homebuyer who can pay off the entire mortgage during the fixed-rate years of the loan can save thousands of dollars in interest. That said, this is a financially heavy lift for many borrowers. A smaller-scale version of this approach is to pay extra toward the principal during the teaser period.
For borrowers hoping to pay off their loan early, however, caution is appropriate. Depending on the lender and the loan terms, borrowers can be subject to prepayment penalties if they refinance or pay off the loan sooner than anticipated. Lenders predictably tend not to highlight these penalties, so it is important for borrowers to look for them before selecting a mortgage. An ARM can potentially bear two types of prepayment penalties: a hard prepayment penalty or a soft prepayment penalty. If an ARM has a hard prepayment penalty, a homeowner will be penalized for selling or refinancing their home during the penalty period. An ARM with a soft prepayment penalty allows a homeowner to sell their home freely, but penalizes refinancing the mortgage. ARMs with prepayment penalties tend to offer lower initial interest rates, which means many borrowers can opt for them without fully understanding the penalties they may face if they hope to refinance or pay off their loan before the adjustment period kicks in.
When it comes to refinancing or other prepayments, borrowers should keep in mind that unforeseeable events can arise in the future. These events may be personal, such as a divorce or a lost job; they can also be market events, such as interest rates that continue to rise. There is no guarantee refinancing an ARM will leave borrowers in a better place (apart from the lower rate available during the teaser period) than just committing to a traditional fixed-rate mortgage.
With national borrowing rates hitting multi-decade highs in 2022, many buyers may find an adjustable-rate mortgage attractive. In certain situations, ARMs can be beneficial. But for many, they can have serious and potentially catastrophic downsides. Borrowers should consider their own current and anticipated future circumstances, pay close attention to the specific terms of any mortgage that is offered, and approach any ARM with caution.