Should You Consider an Adjustable-Rate Mortgage?
Between September 2021 and September 2022, the rate on a 30-year fixed mortgage more than doubled to 6.08%, a level not seen since 2008. As a result, applications for adjustable-rate mortgages—or ARMs, which offer a lower initial rate for a fixed term before shifting to a variable rate—more than tripled in the first half of 2022 as homebuyers looked for ways to reduce their borrowing costs.
"An ARM's lower initial rate can be attractive, but the variable rate can jump quite a bit once the fixed term ends," says Chris Kawashima, CFP®, a senior research analyst at the Schwab Center for Financial Research. That said, ARMs can be a strategic borrowing solution under certain circumstances, provided you can justify the closing and other costs. For example, an ARM could make sense if:
- You plan to pay it off before the introductory-rate period ends.
- You plan to use it to purchase an investment property that you will sell before the fixed-rate period ends.
- You plan to use it as a bridge loan to purchase a new home while waiting for your current home to sell, at which point you plan to pay off the ARM in its entirety.
- You own your primary home outright and plan to obtain an ARM on that home in order to purchase a second property. "You'll have to pay closing costs—and the loan is limited to 80% of your primary home's equity—but unlike a home-equity loan, the interest on up to $750,000 in mortgage debt is fully deductible," Chris says.
However, if any of your assumptions—such as your ability to pay off the loan during the introductory term—prove to be incorrect, you could face significantly higher costs once the variable rate kicks in. "Ultimately, your finances need to be able to absorb that kind of shock," Chris says.
How ARMs work
When researching ARMs, you'll typically notice two numbers: The first is the length of the fixed-rate term, and the second is how often the interest rate adjusts up or down once the initial term ends. A 5/1 ARM, for example, has a fixed rate for the first five years, then resets every year thereafter.
An ARM's interest rate is the sum of two rates: the margin, which is set at the time of the loan's creation and is fixed for the life of the loan, and the index, which is a benchmark rate that varies in response to market conditions.
"Fortunately, ARMs usually have caps on the initial rate increase, subsequent increases, and total increases over the life of the loan," Chris says. For example, a 5/1 ARM with a 2/2/5 cap means the rate can increase by a maximum of two percentage points at the time of its first adjustment and by a maximum of two percentage points per adjustment thereafter, but the total increases over the life of the loan cannot exceed five percentage points.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
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