Adjustable-rate mortgages (ARM) accounted for 9.8% of mortgage applications in the week ending Sept. 18, as borrowers sought relief from higher fixed rates.
An ARM can lower the initial monthly payment, but its rate and payment may rise after the introductory period.
Buyers should compare the possible payment after a rate increase with what they can afford, even if they expect to sell or refinance.
Nearly one in 10 mortgage applications last week were for adjustable-rate mortgages, or ARMs, according to the Mortgage Bankers Association (MBA).
The ARM share reached 9.8% for the week ending Sept. 18 as the average contract rate on a conforming 30-year fixed mortgage rose to 7.12%. The average rate on a 5/1 ARM was 6.10%. Those are survey averages; an individual borrower’s offer will depend on the loan and lender.
The appeal is the lower starting rate. A 5/1 ARM keeps its initial rate for five years. Typically, it would then go up or down on an annual basis.
On a hypothetical $400,000, 30-year loan, the two rates in the MBA survey would produce initial principal-and-interest payments of about $2,424 a month with the ARM, compared with $2,694 with the fixed-rate loan — a difference of roughly $270 a month. The example excludes taxes, insurance, fees, and differences between loan offers.
That saving comes with uncertainty. After the fixed period ends, an ARM’s rate changes under a formula set out in the loan agreement, generally using a market index plus a lender’s margin. If the resulting rate rises, the monthly payment generally rises, too. If it falls, the payment may decline, subject to the loan’s terms.
When an ARM may help
An ARM can make sense for a buyer who can comfortably afford the loan and expects to move before the first adjustment. The initial savings could also give a household room to build reserves or pay down the loan balance.
But a plan to sell or refinance is not a guarantee. A buyer may stay longer than expected, mortgage rates may remain high, or a decline in home value or income may make refinancing harder. The borrower would then face the ARM’s adjustment under its existing terms.
Rate caps limit how much an ARM rate can change at its first adjustment, at later adjustments, and over the life of the loan. A cap limits the increase; it does not guarantee an affordable payment. The Consumer Financial Protection Bureau (CFPB) advises borrowers to ask lenders to calculate the highest payment the loan could require.
Before choosing an ARM, buyers should compare loan estimates for both loan types, including the starting rate, closing costs, adjustment schedule, index, margin, and caps. They should also check whether the loan has a minimum rate, called a floor, or a prepayment penalty.
The most useful test is a household budget: Could it cover the payment after a substantial rate increase, alongside property taxes, insurance, and other housing costs? If the answer depends on refinancing before the rate adjusts, the initial saving may carry more risk than it appears.