With 30-year fixed mortgage rates hovering above 7% since mid-September, more homebuyers are turning to adjustable-rate mortgages to lower their monthly payments.
The appeal is simple. ARMs typically offer lower interest rates than traditional 30-year fixed-rate mortgages, at least initially. And recently, the discount rate has increased significantly. According to the Mortgage Bankers Association, the average interest rate for five-year fixed-rate ARMs that adjust annually was 6.41% as of late October, nearly one percentage point lower than the average 7.37% for 30-year fixed-rate ARMs. This difference saves many borrowers hundreds of dollars per month during the initial fixed rate period.
This helps explain why ARMs on mortgage applications increased from 8% in early September to 11.3% in late October, according to MBA data.
However, lower interest rates come with pitfalls. Unlike traditional fixed-rate mortgages, ARMs typically lock in your initial interest rate for only a short period of time. It often takes 5, 7, or 10 years. The interest rate then adjusts periodically based on changes in the benchmark interest rate, potentially increasing the borrower’s monthly payments.
For some borrowers, the gamble is whether mortgage rates will fall enough to refinance to a fixed-rate mortgage before the ARM adjusts. That way, you can enjoy lower payments now and lock in a larger fixed rate later.
But if interest rates rise instead, you could end up with higher monthly payments than you can afford.
“Refinancing should be treated as an upside scenario, not an exit strategy, because neither future interest rate reductions nor loan approvals are guaranteed,” said Michael Young, director of home lending at Wealthfront.
That’s why experts recommend stress testing your ARM before signing to see if you can afford the monthly payments even if interest rates rise.
Stress test your variable rate mortgage offer first
First, compare your monthly payments on an ARM to what you’d pay on a traditional 30-year fixed mortgage.
For example, a $400,000 mortgage with a 30-year fixed rate of 7.37% will cost you approximately $2,761 per month in principal and interest.
If your ARM interest rate is 6.41%, your payments will drop to about $2,505, a savings of about $256 per month, or $15,400 over the first five years.
However, there is no guarantee that the savings will last. After an introductory period, your ARM interest rate can increase subject to a limit known as a rate cap.
For example, a five-year ARM that starts at 6.41% could rise to 8.41% in the sixth year and 9.41% in the seventh year, subject to the prevailing interest rate cap. If the interest rate stays at 9.41% through the 10th year, the borrower would end up paying about $10,250 more over the first 10 years of the mortgage than someone who chose a 30-year fixed mortgage, even after taking initial savings into account.
Also, even if mortgage rates drop, refinancing is not guaranteed. Borrowers need to qualify for a new loan, which can be complicated by changes in income, employment, or home equity.
Use the calculator below to see how rising interest rates could affect your mortgage costs and whether refinancing to a fixed rate mortgage could save you money. It also shows that even if mortgage rates fall, refinancing doesn’t always work out. Closing costs can negate the savings from lower interest rates.
For example, refinancing a 6.41% ARM to a 6% fixed-rate mortgage after five years could, under the calculator’s assumptions, cost about $2,000 more than keeping the ARM, assuming interest rates remain the same.
Still, that extra cost may be worth the peace of mind that mortgage rates won’t rise in the future. Ultimately, the sweet spot for refinancing depends on how low interest rates fall, closing costs and how much risk you’re willing to take, says Nick Panays, president of Westgate Capital Ventures, a commercial mortgage lending and brokerage firm.
“If a customer has meaningful savings for the first five to seven years and is comfortable handling the loan when the interest rate adjusts, that’s a good case for an ARM,” he says. “If you refinance at a lower interest rate, that’s just an added benefit.”
