Adjustable-rate mortgages are back. Here’s what to know
Believe it or not, adjustable-rate mortgages are back. These variable-interest home loans may sound like a good deal, but they’re also a good way to get burned.
If you aren’t familiar with adjustable-rate mortgages, it may be because they were extremely unpopular for about fifteen years, thanks to their role in the 2008 financial crash.
At the time, banks were offering borrowers adjustable-rate mortgages with extremely low introductory interest rates, even though many of these borrowers under different circumstances can’t afford their monthly mortgage payments. As interest rates went up, people began missing payments. Many homes ended up in foreclosure, several banks and investment brokerages failed, and the rest — as they say — is history.
Today’s adjustable-rate mortgage is a much safer option for both banks and consumers, thanks to federal legislation that prevents predatory lending. But just because these new-and-improved mortgages are better for borrowers doesn’t mean that an ARM is the best choice for you.
If you’re thinking about getting an adjustable-rate mortgage, read this first. Then ask yourself whether you still want to sign up for a mortgage with variable interest rates.
What is an adjustable-rate mortgage?
Adjustable-rate mortgages, also known as ARMs, give homeowners the opportunity to take out a mortgage at a lower interest rate than they might have gotten with a fixed-rate mortgage — for a limited amount of time. After the initial interest rate expires, the interest rate charged by your lender automatically adjusts at periodic intervals based on a predetermined index.
Essentially, your ARM interest rate starts to shift, and not necessarily for the better.
“Adjustable-rate mortgages are the sophisticated person’s home loan gamble,” says Lawrence Delva-Gonzalez, a federal auditor and financial literacy educator who runs The Neighborhood Finance Guy. “If interest rates go up, your home loan rate will go up and so will your monthly payments. If rates go down, your payments will go down as well.”
Are adjustable-rate mortgages a good idea right now?
If you’re thinking about an adjustable-rate mortgage in 2022, you need to think long-term. You also need to consider not only your own financial health, but the health of the U.S. economy.
People who bought homes during the pandemic were able to take advantage of historically low interest rates, and many homeowners with good credit were able to get 30-year fixed-rate mortgages for between 2% and 3% APR. People who are applying for mortgages right now are likely to pay closer to 7% APR. And, thanks to our current inflationary environment, it’s likely that we’ll see mortgage rates go up before they start to go down again.
“It might be awhile before we return to 2% mortgage interest rates,” Delva-Gonzalez explains. “The Federal Chair hinted way back in February that it took over 20 rate hikes to reel in runaway inflation in the late 1970s and early 1980s. It could take another 20 rate hikes this time around.”
In other words, be wary of taking on a loan with variable interest rates right now. If you apply for an adjustable-rate mortgage, you might pay less interest today. But if the Federal Reserve continues to raise interest rates, you could get stuck paying a lot more than you anticipated.
“It will take a lot to get back to normal,” says Delva-Gonzalez.
How can you use an adjustable-rate mortgage to your advantage?
If you know what you’re getting into, you can get a lot out of an adjustable-rate mortgage. The trick is to plan ahead, and get as much of your mortgage paid off as possible before your interest rates begin to shift.
“The big idea with mortgages is to pay them off sooner,” Delva-Gonzalez explains. “Doing so in less time saves you on interest no matter which loan you use.”
If you’re considering an ARM, Delva-Gonzalez suggests budgeting for a higher interest rate than the teaser rate you may be initially offered. This gives you a surplus of money, plus a little wiggle room.
“Use the surplus for additional payments to principal,” says Delva-Gonzalez. If your interest rates go up, your surplus savings could help you make your monthly mortgage payments without having to cut back on other expenses. If your interest rates go down and you continue making the same monthly payments, your mortgage could get paid off that much faster.
That said, if you can afford to pay a higher interest rate right now, you may want to consider a fixed-rate mortgage instead of an ARM. “I’m a bigger fan of keeping the numbers simple with a fixed-rate option,” Delva-Gonzalez explains. “These changes up or down only complicate budgeting for the short and long term.”