Should you consider an adjustable-rate mortgage?

By Michele Lerner (washingtonpost.com)

With mortgage rates spiking in recent weeks to levels not seen for more than a decade, home loan borrowers are considering their options for financing. Approximately 11 percent of mortgage applications were for adjustable-rate mortgages (ARMs) in the first week of May, according to the Mortgage Bankers Association — nearly double the share of ARM applications three months ago, when mortgage rates were lower.

We asked three mortgage lenders for advice about ARMs: Brian Koss, executive vice president of Mortgage Network in Danvers, Mass.; Tom Trott, branch manager of Embrace Home Loans in Frederick, Md.; and Kate Gurevich, managing director of Found It Home Loans, a division of Cherry Creek Mortgage in Denver. All three responded via email, and their responses were edited.

Q: Are you finding more borrowers want ARMs now? Are these repeat buyers, first-time buyers or both?

Koss: Borrowers are more open to ARMs right now due to the potential savings. Each situation is different, but we are seeing interest from both first-time and repeat buyers.

Trott: More buyers are certainly reviewing their options as they relate to adjustable-rate mortgages vs. fixed-rate mortgages. In my experience, most first-time home buyers are continuing with 30-year fixed-rate mortgages. Repeat buyers are more open to choosing an ARM.

Q: Why do borrowers want an ARM when rates are rising? Shouldn’t they be worried about rates rising too much?

Gurevich: An ARM can still be advantageous if a borrower knows that they will not carry the property for the typical 15- or 30-year term of a fixed-rate mortgage.

Trott: When rates are rising, borrowers are more likely to consider an ARM with the hopes of rates declining in the future. Some borrowers may know that they only will own the property (or have it financed) for five to 10 years, so an ARM is ideal for their financial plan.

Q: What are the advantages of an ARM?

Koss: ARMs come with a lower rate for an initial period, such as five, seven or 10 years, so the monthly mortgage payment is significantly less than a 30-year-fixed rate loan. Even if the rate adjusts higher in the future, the borrower will usually be making more income by then.

Trott: An ARM provides increased cash flow upfront because of the lower rates associated with the fixed-rate portion of the mortgage before the rate adjusts. An ARM will allow a borrower to more comfortably afford a more expensive home with lower payments.

Q: What are the disadvantages of an ARM?

Gurevich: An ARM will typically have a lower interest rate than a fixed-rate mortgage. However, the homeowner will be subject to market volatility and unpredictable interest rates down the road. If rates rise much higher, it could significantly increase a consumer’s housing payment and potentially put them in financial hardship.

Koss: No one knows for certain what will happen with rates. If rates increase, the borrower might not be in the best financial shape to handle the higher payment.

Trott: The disadvantages in an ARM are related to future uncertainty of the interest rate environment. If the interest rate goes up 2 percent (from 4 to 6 percent) on a $500,000 loan, the principal and interest payment is increased by $610 per month.

Q: Please briefly explain how ARMs work.

Trott: ARMs are set up with an initial fixed-rate period, which is usually five, seven or 10 years. Once the fixed-rate period expires, the rate typically adjusts every six months or yearly.

The new interest rate is determined by a published index plus a margin. If the index is 5 percent and the margin is 2.25 percent, then the new rate would be 7.25 percent. There are caps on how much the rate can increase at the first adjustment as well as subsequent ones. In the above example, if the initial rate was 4.5 percent and the interest cap on the adjustment period was 2 percent, then the new rate would be 6.5 percent instead of 7.25 percent.

Koss: For the initial loan period, usually five, seven or 10 years, you’ll have a lower fixed rate. Depending on your loan terms, at the end of that period, the rate can potentially go up 2 percent a year, but never more than 5 percent over the life of the loan. The rate can go down, too. After the initial, fixed-rate period, your new payment will adjust based on the remainder of principal at that time. For example, your rate may go up 2 percent, but your loan balance may be $40,000 lower.

Q: Any advice on who should consider an ARM and who shouldn’t?

Gurevich: An ARM may be a good option if the borrower knows they will not be keeping the property longer than the fixed-rate period of the ARM. A borrower may choose an ARM if they have the financial ability to withstand major interest rate fluctuations and potentially a significantly higher payment as well. Some borrowers also choose an ARM if they strongly believe that the current trend of high and climbing interest rates is unsustainable, and that rates will drop and allow them to refinance in the future. Most borrowers, however, prefer the financial security of a fixed-rate mortgage product.

Trott: If you have good financial discipline, an ARM is a viable option. If you carry a significant amount of debt that is likely to increase over time, an ARM can be dangerous for you financially. The borrowers who are best served by ARMs are the ones who know their mortgage will be on the property only for the initial fixed-rate period. This scenario avoids the future interest rate uncertainty.

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