Adjustable-rate mortgages can carry some risks, but as rates rise, more home buyers may consider them. ARMs typically have a lower initial interest rate than 30-year fixed-rate mortgages, but the rate will change after a defined duration. Borrowers then must pay the rate set when their lock period expires, which can be risky if rates are moving up at the time.
Even though interest rates currently remain at historical lows, recent increases have been a shock to some home buyers’ budgets. Rates have jumped by more than 90 basis points in just one month. Higher borrowing costs have coincided with higher home prices, too. The median list price for a home has reached $405,000, up 14% compared to a year ago, according to realtor.com®.
The 30-year fixed-rate mortgage, the most common loan option, averaged 4.67% last week, according to Freddie Mac. That is the highest average since late 2018.
On the other hand, the five-year ARM averaged 3.5% last week.
Borrowers considering an ARM need to weigh how they’d be able to handle mortgage rate increases after their fixed-rate term expires, typically after three, five, or seven years. An ARM typically comes with caps on the annual adjustment, but these can vary among lenders.
For example, lenders may cap the increase for the first adjustment at 2 percentage points. That would mean the new rate can’t be more than 2 percentage points higher than the initial rate, CNBC explains. A subsequent adjustment cap clause would tell the borrower how much the interest rate could increase in following adjustment periods. Borrowers should review all potential caps and risks fully with a lender before deciding which loan product to choose.
“I’d also be concerned if you do an ARM with a low down payment,” Stephen Rinaldi, president and founder of the mortgage broker firm Rinaldi Group, told CNBC. “If the market corrects for whatever reason and home values drop, you could be underwater on the house and unable to get out of the ARM.”
Rinaldi told CNBC that ARMs often are chosen for purchasers of high-priced homes because the amount saved with the initial rate could be thousands of dollars per year. But for mortgages under $200,000, the savings could be less, he says.