Home buyers have had to accept that mortgage rates probably won’t drop back down to record lows anytime soon.
The average 30-year fixed rate was 5.3% as of Thursday, according to the government-backed mortgage buyer Freddie Mac. That’s up from 2.8% a year ago.
Because of higher mortgage rates and still-rising home prices, fewer aspiring buyers can afford to purchase homes. “We are seeing people become a little desperate,” said Jacob Channel, senior economist at the online lending marketplace LendingTree.
Enter the adjustable-rate mortgage. During the first half of 2022, as interest rates climbed, the share of adjustable-rate mortgages nationwide rose from 3% to 10% of loans, according to the Mortgage Bankers Association.
These loans start at “teaser” interest rates that are typically lower than fixed-rate loans. After a certain number of years, the rate periodically adjusts based on economic conditions.
“People ask about them always when interest rates are rising,” said Phil Giordano, director of Republic Bank’s residential mortgage division, “yet very few in the long run elect to take them.”
He said that in the last 90 days, he has seen the number of adjustable-rate loans in the bank’s pipeline increase about 5%. Republic lends in the tristate area and New York.
Mortgage rates still are at historic lows compared to the double-digit rates of the 1980s, and fixed-rate mortgages remain the most popular choice among home buyers. The 30-year fixed rate is down from about 5.8% in June.
Why do buyers choose an adjustable-rate mortgage?
The average interest rate for a mortgage in which the rate stays the same for five years and then adjusts annually — a common agreement called a 5/1 ARM — was 4.29% on Thursday, according to Freddie Mac. That’s up from a year ago but about a percentage point lower than the 30-year fixed rate.
“It really makes sense why some people might be going toward ARMs, instead,” said Erika Giovanetti, loans expert at U.S. News & World Report.
A percentage point may not seem to be much of a difference, but homeowners potentially could shave hundreds of dollars off their monthly payments.
A lot of borrowers use adjustable-rate mortgages “kind of like a temporary tool,” Giovanetti said. They consider that if they sell their home or refinance their loan within the period when their interest rate is fixed, they won’t have to deal with unknown rates.
If homeowners have a lot of cash or anticipate higher income, they may not be as concerned about the possibility of higher interest payments in the future. And adjustment caps determine how much the interest rate can change.
Why does a resurgence of ARMs make some people nervous?
When Giovanetti first heard that adjustable-rate mortgages were becoming more popular, she said, “it brought me back to the early 2000s housing game.”
“At first I felt quite worried it was a bad sign of things to come,” she said.
In the years before the Great Recession, about a third of all mortgages were adjustable rate. Borrowers who couldn’t qualify for other types of loans took on mortgages at attractive interest rates that later ballooned to unaffordable levels. Foreclosures and the collapse of the housing market followed.
But Giovanetti’s second thought was that the market is in a very different place than it was then. The loan servicing industry is more regulated, and lenders are more concerned with making sure borrowers can afford loans.
“Even if you are getting an adjustable-rate mortgage today, you’re probably in a better position to handle it than someone 15 years ago,” Channel said. “That ultimately goes to show there isn’t as much cause for concern that this is going to lead to some other crash.”
And even with the growth of adjustable-rate mortgages, they still make up only about 10% of all mortgages.
What should homeowners keep in mind?
“The whole ‘adjustable’ part of adjustable-rate mortgages is something you have to be careful about,” Channel said. For a lot of people, “their best bet is still going to be a fixed-rate mortgage. Because it brings with it a sense of security.”
The main concern is that homeowners may no longer be able to afford payments once their mortgage rates adjust. Because although rates could adjust downward, lenders bet on rates rising. Homeowners could end up spending more monthly and over the lifetime of the mortgage than they would with a fixed-rate loan.
“You’re really taking a lot more risk on,” Giovanetti said. Borrowers “need to understand what they’re getting into.”
Figuring out costs and which of the many different types of adjustable loan terms will work best “is kind of a complicated endeavor,” she said.
Whether these mortgages can be a good idea depends on the value borrowers can get from the initial lower rate. The number of years the interest rate stays fixed varies with the type of loan. When the fixed rate ends, some loans adjust every six months, while others adjust annually.
Life circumstances can derail initial plans to sell before the mortgage rate adjusts. If homeowners choose adjustable-rate loans with the intent to refinance later, they have to factor in closing costs, which typically are 2% to 5% of the total loan amount.
Buyers need to consider their personal situations. For example, a borrower’s credit history helps determine interest rates.
Home buyers should speak to mortgage lenders and even a financial adviser about their options, Giovanetti said, and examine loan estimates of various products. Government-backed loans, for example, often offer lower fixed rates than conventional counterparts.
Ultimately, the difference in the amount a buyer will pay in interest for fixed-rate versus adjustable-rate loans should not be the deciding factor in whether a house is affordable, Giordano said. And “if that’s the case, you probably can’t even afford [the loan] at the adjustable rate,” he said, and should look at lower-priced homes.
