ARMs in focus: rising interest rates and the surge of adjustable-rate mortgages

Over the past year, the U.S. mortgage landscape has transformed significantly, with mortgage interest rates experiencing a steady and relentless increase. Starting from 3.26% in 2022, the average interest rate on a 30-year fixed-rate mortgage surged to 6.47% by the end of the year. As of June 2023, this rate has continued to ascend, currently teetering around 7.2%

Given these trends, adjustable-rate mortgages (ARMs) gained traction as an alternative to the traditional fixed-rate mortgage. ARMs have seen a steep rise in popularity, with these loans peaking at almost 13% of mortgage applications in late 2022, according to the Mortgage Bankers Association Weekly Applications Survey. This marks a dramatic shift from 2021 when ARM loans represented a mere 2% of mortgage applications.

Understanding how ARMs adjust

ARMs have interest rates that can change over time based on market conditions. The rate adjustments are generally determined by a reference interest rate or index plus a margin determined by the lender. 

To understand how ARMs adjust, let’s look at a 10/1 ARM as an example. The “10” represents the number of years the interest rate will stay fixed, and the “1” represents how frequently the rate will adjust after that initial period. In this case, the interest rate will remain constant for the first ten years and adjust annually thereafter. A 10/6 ARM will be fixed for ten years, and then the interest rate will be adjusted every six months afterward for the duration of the loan. 

While the interest rates on ARMs can adjust over time, there are usually protections or “caps” that limit how much the interest rate can increase or decrease. These caps come in three forms: 

  1. The initial adjustment cap limits how much the interest rate can change during the first adjustment. For instance, an ARM may have an initial adjustment cap of 2%, which means the interest rate can’t increase or decrease by more than 2% on the first adjustment. 
  2. The periodic cap limits how much the interest rate can change during any adjustment period after the initial adjustment. 

  3. The lifetime cap is the maximum limit the interest rate can adjust over the life of the loan. For example, if your initial interest rate is 4% and your loan has a lifetime cap of 6%, the highest your interest rate could ever be is 10%.

The cap structure is often displayed as a [Initial Adjustment Cap]/[Periodic Cap]/[Lifetime Cap]. For example, a 2/1/4 cap structure has an initial cap of 2%, a periodic cap of 1%, and a lifetime cap of 4%. 

Some ARMs include an interest-only option that enables the borrower to pay only interest on the loan for a set period. While interest-only payments help to reduce the monthly payment for the period, the borrower faces two risks. First, if the borrower only pays interest and not principal during the set period, the principal will be amortized over a shorter period creating higher monthly payments in the future. Second, if the home loses value during the interest-only period, the loan-to-value ratio may become problematic; in a worst-case scenario, the loan balance may exceed the home value, referred to as being underwater.   

The risks of adjustable-rate mortgages

The allure of ARMs can be substantial, especially with the climbing rates of traditional fixed-rate mortgages. However, it’s essential to remember that ARM interest rates are not permanent fixtures. If you’re considering an ARM, it’s crucial to understand the associated risks and plan accordingly. 

ARMs are characterized by their sensitivity to market interest rates. Unlike their fixed-rate counterparts, the interest rate of ARMs can fluctuate with market rates. Such volatility exposes borrowers to the risk of potential interest rate increases. For example, if you took out a 10-year ARM in 2013 when rates were around 3.9%, you’ve likely seen a staggering increase in your interest rate for 2023. As of June 20, 2023, the average 10/1 ARM APR was 7.97% (an increase of 4.07%).

This surge in rate can lead to higher monthly payments, which can strain a borrower’s financial capabilities. Payment shock, the sudden and significant increase in monthly mortgage payments when an ARM adjusts can pose a particular challenge if the borrower’s income does not rise proportionately. 

Considering the previous example, if the homebuyer purchased a home with a 10-year ARM in 2013 for $402,500 (the national median at the time), their total monthly mortgage payments would have increased from roughly $1,899.33 to $2,945 in 2023. Please note that these numbers are illustrative, and actual amounts can vary based on the specific terms of the loan, the timing of payments, and any additional charges like mortgage insurance or escrow for taxes and insurance.

Financial experts often recommend that your monthly mortgage payments should not exceed 25% of your gross income. Therefore, it’s vital to evaluate potential mortgage increases and your ability to sustain higher payments under less favorable circumstances. Contemplating worst-case scenarios isn’t pessimistic; it’s prudent. In the long run, the stability of your home shouldn’t be a gamble but a carefully calculated certainty. 

Using ARMs strategically

In a high-interest rate environment like the present, using an ARM might be a strategic move. First, many ARMs offer lower interest rates than a 30-year fixed-rate mortgage. If a borrower plans on selling the house or refinancing within the initial period, they may be able to take advantage of the lower initial interest rate without being exposed to the risk of potential interest rate increases later on. 

Additionally, some borrowers may opt for an ARM if they believe interest rates will fall in the future. This is because, after the initial fixed-rate period, the interest rate on an ARM can adjust up or down depending on market conditions. If interest rates decrease, the interest rate and monthly payments on the ARM would also decrease (without the need for refinancing and its associated costs), potentially saving the borrower money. 

Remember, it’s essential to understand the terms of any mortgage before you commit. Consult with your financial advisor, read all terms thoroughly, and ensure you’re prepared for different scenarios, including the maximum potential increase in payments. 

Adjustable-rate mortgages offer potential savings and flexibility, but they come with financial risks linked to changing interest rates. Therefore, these types of mortgages should be chosen carefully, with thorough consideration of your financial situation, future market shifts, and longer-term plans. Despite the uncertainties, when used prudently, they can serve as a valuable tool for potential borrowers. If you have any questions or would like to discuss your financial planning, please contact our office to discuss with an expert advisor.

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