In 2022, interest rates were volatile, and although they calmed a bit in the first half of 2023, the July Federal Reserve announcement of its intention to resume interest rate hikes has again created interest rate uncertainty. The Federal Reserve, the central banking system of the US, stated that its policy rate would increase to between 5.25% to 5.5% (as of September 25, 2023.)
So, not only do potential homebuyers need to find the perfect property in their ideal neighborhood, but they also must figure out the best type of mortgage for their needs and budget. While fixed-rate mortgages are a popular choice due to their stability, adjustable-rate mortgages (ARMs) offer certain benefits that make them more attractive depending on individual circumstances.
Choosing the right mortgage is one of your client's most important decisions. The financial implications are long-term, so it’s vital to ensure that your clients are fully informed when deciding. Although the lender will ultimately be the point person for specific loan questions, your job as a real estate professional is to guide your clients through the often overwhelming buying process and offer sound input during the financing process.
What Is an Adjustable Rate Mortgage?
An ARM is a type of mortgage where the interest rate is not fixed but changes periodically according to market conditions.
Typically, the interest rate on an ARM will be low during the initial period of the loan and then adjust upward (or downward) based on fluctuations in the market. The initial period could range from one to ten years, depending on the type of ARM.
How Does an Adjustable Rate Mortgage Work?
With an ARM, the interest rate will change after the initial fixed-rate period, which can be higher or lower depending on current market conditions.
If interest rates drop, the monthly mortgage payment could decrease, resulting in savings for the home buyer. Conversely, if interest rates rise, the monthly mortgage payment will increase, potentially resulting in a more significant financial obligation for the homeowner.
ARMs typically come with an initial fixed-rate period, so prepare to help your clients compare options. Often ARMs are 5/1, meaning the interest rate is the same for the first five years, then the rate can fluctuate yearly. Alternatives include 5/6, where the first five years, the interest rate is the same before the rate can fluctuate every six months, or 3/1, where the first three years are fixed with potential fluctuations every year after that.
Generally, the shorter the fixed rate period, the lower the initial interest rate.
However, caps are put in place to limit the amount your rate can increase over time. There are three types of caps on ARMs:
- A periodic cap limits the percentage of the interest rate that increases when the initial period is over.
- A lifetime cap is a cap on the maximum interest rate that can be charged during the entire life of the loan.
- The monthly payment cap limits how much monthly payments can increase, regardless of what happens to the interest rate.
Differences Between Fixed vs. Adjustable Rate Mortgages
The main difference between a fixed-rate mortgage and an ARM is that with a fixed-rate mortgage, the interest rate is locked in for the life of the loan, while with an ARM, the interest rate changes.
Fixed-rate mortgages are typically a good option for homeowners who want to predict their monthly mortgage payments over the life of the loan. ARMs can be a good option for homeowners comfortable taking on some risk in exchange for lower interest rates during the initial loan period.
Top 7 Points to Consider About Adjustable Rate Mortgages
While fixed mortgages remain popular, ARMs can offer some advantages, especially for specific borrowers. Let’s take a look at the top seven things to consider when deciding whether an ARM is right for your clients:
#1 Length of Ownership
An ARM could be a good option if the home buyer plans to sell the property, pay off the mortgage, or refinance in a few years.
On the other hand, if the buyer plans to own the property long-term, a fixed-rate mortgage might be a better option. ARMs have a fixed interest rate for a set period, after which the rate will adjust periodically based on an index. If the home buyer plans to own the property long-term, they may want to avoid the risk of higher interest rates in the future and opt for a fixed-rate mortgage.
#2 Credit Score and Credit History
The interest rate a borrower receives on an ARM will depend on a few factors, including credit score and credit history. Lenders use credit scores to gauge creditworthiness and the likelihood that the borrower will pay on time.
If the home buyer has a low credit score, they may not be eligible for an ARM or need to pay a higher interest rate than someone with a higher score. Although, there are steps they can take to improve their credit over time.
#3 Savings vs. Certainty
The home buyer will have to consider their priority: savings or certainty. ARMs have lower initial interest rates, which can save the borrower money in the short term.
However, after the fixed rate period ends, the interest rate will adjust, and monthly mortgage payments could increase. If the borrower values certainty and wants to know exactly what their monthly payments will be over the life of the loan, then a fixed-rate mortgage may be the wiser option.
As a real estate professional, it’s important to have honest conversations with your client about their financial goals and the upsides and downsides of ARMs.
#4 Stable Income vs. Changing Income
An ARM may make sense if the home buyer has a stable income and expects it to stay the same or increase. However, a fixed-rate mortgage may be a better choice if their income is less predictable or changing.
With an ARM, the interest rate can change, which means monthly payments can also change. This could be risky if the borrower’s income is unstable or prone to change.
#5 Rate Caps
ARMs typically come with rate caps that limit how much your interest rate can increase in any given year or over the life of the loan.
This protects against large interest rate spikes, which can help you better plan your monthly budget and reduce concern that soaring rates could push home buyers into financial turmoil.
#6 Timing Is Important
When suggesting an ARM to your clients, timing is critical.
For example, if interest rates are low, it may be an ideal time for your clients to consider an ARM. Plus, an ARM with a low introductory rate could be a reasonable choice if they plan on a short-term home purchase. However, if interest rates are high or expected to change in the coming years, it may not be the best time to recommend an ARM.
The most significant risk with an interest rate increase is going upside down on a mortgage—meaning the homeowner owes more on the house than it’s worth.
As a real estate professional, consider suggesting an ARM to clients only after carefully considering market trends.
#7 Analyze Risk
ARMs come with some uncertainty since the interest rate can change. If you’re risk-averse, a fixed-rate mortgage may be a better choice. However, an ARM could be a great fit if you’re comfortable with some risk and want to take advantage of potentially lower interest rates.
Is An ARM Right for Your Clients?
As a real estate professional, you can suggest various mortgage options to your homebuyers. But determining which is suitable for your clients can be a challenge. In addition to seeking your expertise, homebuyers should contact their chosen lender with any questions since they would likely be the go-to contact to help clients identify the right loan based on their financial circumstances.
Here are a few insights on when it might be appropriate to suggest an ARM to homebuyers:
Consider Which Type of ARM
Before suggesting an ARM to your clients, it's essential to understand which type suits their needs. There are three main types of ARMs, including:
- Interest-only ARM is when a borrower can pay only the interest on their loan for a specified period.
- Payment-option ARM allows the borrower to pay different amounts each month, including a minimum required payment.
- Hybrid ARM combines fixed and variable-rate mortgages, where a borrower pays a fixed interest rate for a specified period before it changes to a variable rate.
Understanding which type of ARM your clients need is key to providing fitting mortgage options.
Know the Current ARM Rates
Since ARM rates fluctuate based on market trends, as a real estate professional, staying abreast of current ARM rates is vital to advise your clients appropriately.
Suppose the current ARM rates are relatively low compared to fixed rates. In that case, you can suggest an ARM to clients who prefer lower initial loan payments to refinance to a fixed-rate mortgage before their rates become unpredictable.
Consider Using an ARM Calculator
Calculating the monthly payment for an ARM can be complicated due to the fluctuating interest rates, so using an ARM calculator can be incredibly helpful.
These calculators use data such as initial interest rates, margins, and caps to help your home buyers understand how much their monthly payments will be in different scenarios. With this information, you can help your buyers prepare for potentially higher payments when the interest rates adjust.
Adjustable Rate Mortgages for Real Estate Professionals
It's important for real estate professionals to consider all the various factors when determining whether an ARM might be a viable option for their clients. When evaluating an ARM, it's important for you to help your homebuyers consider the rate caps, how long they plan on keeping the property, if their income is stable or fluctuates, and how it comes together for mortgage payments.
Ultimately, it comes down to analyzing the risks vs. the rewards and understanding the long-term plan of their clients before making such a recommendation. Being familiar with the types of mortgages available and what protections are in place is vital to help guide your clients in the right direction.