Understanding Adjustable-Rate Mortgages (ARMs) in 2023

Introduction to Adjustable-Rate Mortgages

Adjustable-rate mortgages, or ARMs, have become a popular option for borrowers in 2023, especially as mortgage rates remain elevated. Unlike fixed-rate mortgages, which maintain the same interest rate for the entire life of the loan, ARMs offer a lower initial interest rate that adjusts over time. This feature can be appealing for borrowers looking to save money on their monthly payments, but it also comes with risks.

As of January 2023, the average rates for 7/1 ARM and 5/1 ARM loans were approximately 6.78% and 6.83%, respectively, according to data from Zillow. These rates are slightly higher than the average 30-year fixed mortgage rate, which was around 6.71% during the same period. This means that, currently, ARMs may not provide the significant cost savings they often promise. However, the benefits of an ARM depend on the specific terms and the borrower’s financial situation.

How Adjustable-Rate Mortgages Work

An ARM begins with a fixed interest rate for a certain period, known as the initial fixed period. After this period ends, the rate adjusts regularly based on a predefined index, such as the SOFR (Secured Overnight Financing Rate) or the 1-Year LIBOR. The adjustments can occur annually, every six months, or at other intervals, depending on the terms of the loan. For example, a 7/1 ARM offers a fixed rate for the first seven years, after which the rate adjusts annually. Similarly, a 5/6 ARM has a fixed rate for five years and then adjusts every six months.

One important feature of ARMs is the presence of rate caps, which limit how much the interest rate can increase with each adjustment and over the life of the loan. These caps help protect borrowers from drastic increases in their monthly payments. However, even with these safeguards, borrowers should carefully consider their ability to handle potential payment increases before opting for an ARM.

Benefits of Adjustable-Rate Mortgages

The primary advantage of an ARM is the potential for lower initial interest rates compared to fixed-rate mortgages. This can lead to lower monthly payments during the initial fixed period, freeing up more of the borrower’s income for other financial goals, such as saving for retirement or paying off other debts.

Another benefit of ARMs is the possibility of savings if interest rates decline after the fixed period. If the rate drops during the adjustment phase, the borrower’s monthly payments could decrease. In contrast, fixed-rate mortgage borrowers would need to refinance to take advantage of lower rates.

Risks of Adjustable-Rate Mortgages

While ARMs can offer significant savings, they also carry risks that borrowers must carefully weigh. The most notable risk is the unpredictability of monthly payments after the initial fixed period. If interest rates rise, the borrower’s payments could increase, potentially straining their budget.

Another risk is the difficulty of exiting the loan before the rate adjusts. Some borrowers opt for ARMs with the intention of selling or refinancing their property before the fixed period ends. However, unforeseen circumstances, such as a downturn in the housing market or personal financial challenges, can make it difficult to follow through on these plans. Mason Whitehead, a Dallas-based branch manager for Churchill Mortgage, learned this the hard way. He chose a 5-year ARM believing he would sell the property within a few years, but due to the 2008 housing bubble burst, he was still holding the property 10 years later.

Finally, the complexity of ARM terms can be overwhelming for borrowers. With various types of ARMs available, each tied to different indexes and adjustment schedules, it’s crucial for borrowers to fully understand how their loan works before signing.

Are ARMs a Good Idea in 2023?

Whether an ARM is a good choice depends on the borrower’s financial situation and the broader economic outlook. If interest rates are expected to fall in the coming years, an ARM could be a smart move, as the borrower could benefit from lower payments after the fixed period. However, if rates continue to rise or remain elevated, the borrower could face higher payments and regret their decision.

According to most forecasts, mortgage rates are expected to trend downward over the next couple of years. This could make ARMs more appealing, as borrowers might enjoy lower initial rates and potential savings if rates decline. However, it’s important to remember that mortgage rates are influenced by a variety of unpredictable factors, including economic conditions, Federal Reserve policies, and global events such as natural disasters or geopolitical tensions.

For borrowers considering an ARM, it’s essential to prepare for the worst-case scenario. This includes ensuring that they can afford the maximum possible monthly payment and understanding all the terms of the loan, including the index, margin, and rate caps. As Mike Rhoads, owner of Rhoads Home Buyers, advises, “Borrowers should consider their financial situation and ability to absorb potential rate increases before getting an ARM.”

Frequently Asked Questions About ARMs

1. Are ARM rates currently lower than fixed rates?
   In recent months, ARM rates have not been significantly lower than fixed rates, so an ARM might not offer much savings right now.

2. What is the main downside of an ARM?
   The primary risk is that your monthly payment could increase when the rate adjusts, making it harder to budget.

3. Can I refinance out of an ARM into a fixed-rate mortgage?
   Yes, many borrowers refinance their ARM into a fixed-rate loan to lock in a stable rate before the ARM adjusts.

4. How much could my payment increase?
   The potential increase depends on how much rates rise and the terms of your loan, including the rate caps. Your lender can provide more specific information.

5. When is an ARM worth it?
   An ARM might be a good choice if you plan to sell or refinance before the fixed period ends and can get a lower initial rate than with a fixed mortgage.

Conclusion

Adjustable-rate mortgages can be an attractive option for borrowers looking to minimize their monthly payments, but they come with significant risks. While current rates may not make ARMs the most cost-effective choice, they could become more appealing if interest rates decline in the future. Borrowers should carefully evaluate their financial situation and the terms of the loan before deciding. As always, it’s wise to consult with a mortgage professional to determine whether an ARM aligns with your long-term financial goals.