Adjustable-rate mortgages (ARMs) are making a comeback, but whether or not they make sense for you depends on how much risk you can handle.
These type of loans — also known as variable-rate mortgages — are different than traditional fixed-rate mortgages because the interest rate you pay can change at various points over the course of the loan.
ARMs offer introductory rates that are often cheaper than fixed-rate loans, currently about a 0.5% to 1.5% difference. These introductory rates are locked in for the first few years of the mortgage, usually five, seven or 10 years.
With 30-year fixed mortgage interest rates nearly doubling to around 6% since last July, new homebuyers are increasingly turning to ARMs as a way to keep monthly costs down. The share of adjustible-rate mortgage applications has more than tripled to 10.1% since January, according to June data provided by the Mortgage Bankers Association.
"I think people are just looking for some cost relief," says Ralph DiBugnara, founder and president of Home Qualified, an online real estate information resource.
Adjustable-rate mortgages have some risks
However, with ARMs, borrowers risk paying higher monthly payments after the introductory period expires. At that point, the interest rate will change at set intervals, usually every year or six months. The new rate will be based on market rates at that time, which could be higher than the initial rate.
Commonly, ARMs are referred to by their introductory and adjustment intervals, so a five-year ARM with either a yearly or six-month adjustment would be described as either a 5/1 or 5/6 ARM.
While these loans don't offer the cost certainty of 30-year fixed-rate mortgages, some homeowners are willing to risk higher rates if it keeps initial financing costs down. Plus, ARMs have other cost certainty protections in place, since most include caps or limits on how high interest rates can be raised for the lifetime of the loan.
Typically, ARMs include a lifetime cap of about 5% to 6%, which means borrowers will never pay an interest rate more than five or six percentage points higher than the initial rate. There's also a cap for the first rate adjustment after the introductory period, as well as subsequent adjustments — commonly no more than 2%.
You can also bail out of an ARM and switch over to a fixed-rate mortgage by refinancing your existing loan. However, that comes with a price: You'll have to pay closing costs worth roughly 2% to 5% of the new loan.
Who are the ideal borrowers for adjustable-rate mortgages?
ARMs can be a good option for homeowners who plan to sell their home when the introductory period ends. Borrowers with good monthly cash flow are also ideal ARM candidates since the extra cash provides a cushion in case interest rate hikes are maxed out later on in the loan. Other good candidates are those who expect higher income later, after the ARM introductory period expires.
"If a homebuyer thinks that their income will increase, and they believe that [interest] rates will come back down, then an adjustable is the right product," says Melissa Cohn, executive mortgage banker at mortgage servicing company William Raveis Mortgage.
On the other hand, "if their income is capped, and they're afraid to afford anything more, they might be more psychologically comfortable with a fixed-rate mortgage," she says.
When shopping for an ARM, buyers should look for interest rate caps they can afford and avoid additional prepayment penalties, says DiBugnara. Prepayment penalties are charged if you pay off your loan, or too much of your loan, within the first few years. They can range from a set fee of a few thousand dollars to a percentage of the loan, like 2%.
DiBugnara advises buyers to "do the math" on the maximum monthly amount they might pay, using the highest possible interest rate. By looking at the worst-case scenario for monthly payments, buyers will know whether they can afford the loan and whether the initial savings are worth the risk.
Sign up now: Get smarter about your money and career with our weekly newsletter