The perks and pitfalls of adjustable-rate mortgages in 2022

Rising rates make ARMs more prevalent

Historic mortgage rate growth and surging property values have defined the housing market so far in 2022.

With that combination of factors reducing affordability, more borrowers are exploring the option of adjustable-rate mortgages (ARMs).

But are they a good idea? The Mortgage Reports spoke to a trio of industry experts to break down the pros and cons of ARMs for home buyers. Here’s what you should know.

In this article (Skip to...)

• How ARMs work
• Who should use ARMs?
• ARM risks
• Advice for borrowers
• Your next steps

How ARMs work

As the name implies, the interest rate a borrower pays with an adjustable-rate mortgage (ARM) can eventually change, unlike a fixed-rate mortgage (FRM) which has the same rate for the life of the loan.

The type of ARM you get — the most common being 3-, 5-, 7- and 10-year — represents the amount of time your initial interest rate is fixed. In most cases, the lender adjusts the rate annually based on the current market once that initial period ends. For example, a 5/1 ARM means the rate is locked for the first five years and then is adjusted once every year after that.

There’s also a limit to the amount an ARM can increase, which is set by your lender. According to the Consumer Financial Protection Bureau, the most common adjustment caps are 2% or 5% after the initial period, 2% for all subsequent annual adjustments, and 5% for the lifetime of the loan.

When applying for an ARM, borrowers typically need to qualify for the initial interest rate plus two percentage points (and even up to five percentage points). This accounts for the borrower still being able to make monthly payments under the possibility of future interest rate increases. Although, it’s feasible that rates could drop and the adjustable rate may decrease.

Mark Schulenburg, branch manager at Inlanta Mortgage

“One misconception is that ARMs always go up, and that’s not true. When it’s time, the interest rate doesn’t just get adjusted based on the bank’s wants, wishes, needs, and desires … it gets adjusted based on the terms of the mortgage agreements established at the closing and the terms of the ARM.”

Unless stated otherwise, ARMs amortize over 30 years just like their most common fixed-rate counterpart. A borrower can also refinance from an ARM to a FRM if they ever want to.

The “set it and forget it” approach of an FRM offers borrowers security, but knowing how ARMs work and understanding all of their components gives potential for lower monthly payments and/or a bigger home buying budget.

When should a home buyer get an ARM?

During periods of rising interest rates — like we’ve seen this year — ARMs offer a great option for borrowers to save money. As the Federal Reserve plans hikes for each of its remaining 2022 meetings, the mortgage rate surge could continue building momentum.

If you qualify for an ARM, you’ll likely lock in a mortgage rate below fixed-rate loans for a lower monthly payment and the possibility of affording more house. Since 2005, the average 5/1 ARM was higher than the average 30-year FRM during only 5.31% of weeks, according to Freddie Mac.

Freddie’s latest market survey from June 2 showed the 30-year FRM averaged 5.09% while the 5/1 ARM averaged 4.04%. As the 30-year FRM spiked, an increasing number of borrowers opted for ARMs.

For the week ending Jan. 7, ARMs made up just 3.1% of all mortgage applications, according to the Mortgage Bankers Association. The data from May 27 revealed an 8.7% ARM share while it reached a 14-year high of 10.8% on May 6 — right when the 30-year climbed to the highest level since 2009.

While ARMs still fall behind fixed-rate loans in popularity, they can offer big benefits for the right borrower.

Ryan Leahy, inside sales manager at Mortgage Network

“ARMs are great for anybody considering making a move during the fixed-rate period because they can take the lower rate without worrying about the risk associated once it adjusts. For instance, if somebody’s buying a condo and they know they would like to move to a single family home in four years, then we’d propose a five year adjustable rate mortgage to the client.

Another may be someone who thinks they’ll refinance during that fixed rate period. I have clients that believe mortgage rates will go down over the next couple of years. In the interim, they’re choosing an adjustable rate mortgage with a three year fixed period, anticipating there’ll be an opportunity to refinance into a better fixed-rate loan than what’s being offered today.”

Mark Schulenburg, branch manager at Inlanta Mortgage

“There’s a higher cost associated with locking an interest rate for 30 years because the bank doesn’t know what the interest rates are going to be doing over the course of that loan. The longer that a person wants an interest rate to be fixed and guaranteed, the more expensive that’s going to be.”

The case against ARMs

Of course, every coin has two sides and opting for an ARM over an FRM can have drawbacks.

FRMs offer simplicity and predictability by securing a single interest rate over the life of the loan. Conversely, an ARM’s lack of certainty can make borrowers nervous that not locking in a rate could be a mistake in hindsight.

A borrower could have trouble with an ARM if their financial situation worsens and they don’t have the room for a higher monthly mortgage payment in the future.

Jared Maxwell, vice president of direct sales at Embrace Home Loans

“One risk is the uncertainty if there ever was a black swan event and one of the indexes that the ARMs were based on skyrocketed. I would advise a consumer against getting an ARM if they haven’t budgeted for the potential of their payment increasing.

I’d also advise against it if they’re not educated on the index and margin being used on their loan and what the history of that particular index looks like. Prior to the mortgage meltdown during the 2000’s, many of the margins on ARM products were 6%, 7%, or 8% and the consumer was unaware of how an adjustment worked.”

Mark Schulenburg, branch manager at Inlanta Mortgage

“The pitfall associated with an ARM is that if the consumer has not paid off the loan [or refinanced] within that initial period, then the interest rate is going to adjust. And the risk is that it could adjust to a rate that would have been higher than what the 30-year fixed rate would have been if they had just selected that from the beginning.”

Advice for getting an ARM

ARMs aren’t as popular as their fixed-rate cousins, likely because they’re a little more complicated. However, an ARM could give you a lower interest rate and the flexibility FRMs lack.

“If we go into a recession, there’s a high likelihood of [homeowners] being able to grab a lower interest rate or a lower long term fixed interest rate in the future.”

-Ryan Leahy, inside sales manager at Mortgage Network

But ARMs aren’t as straightforward and come in many forms, so they require some legwork and borrowers should be prepared to ask questions.

A few examples of strategic questions to ask before getting an ARM are:

• How long does the initial rate apply?
• When the initial interest rate is due to change, how is that adjusted rate calculated?
• How often can/does the rate change after the initial period?
• What are the limits to how much that rate can change each year and in total?

Lastly, borrowers should ask themselves how long they realistically plan to be in their house before moving. That can really help determine your ideal mortgage type.

Ryan Leahy, inside sales manager at Mortgage Network

“I’m advising borrowers to challenge their assumptions of the time spent in the home and in the loan. Most of my clients believe that this is the last home they’ll ever own in the last loan they’ll ever be in. That’s typically not the case. The average life of a mortgage, I believe, is seven or eight years. So most people are selling or refinancing.

The other thing is many clients believe there may be an impending recession. And mortgage interest rates have dropped after each U.S. recession over the past 40 years. If we go into a recession, there’s a high likelihood of them being able to grab a lower interest rate or a lower long term fixed interest rate in the future.”

Jared Maxwell, vice president of direct sales at Embrace Home Loans

“I don’t have a one-size-fits-all answer. You need to understand every consumer’s particular situation. If an adjustable rate makes sense and provides them a lower payment, then I will be very comfortable to recommend an ARM.

If you’re using a 7- or 10-year ARM term, it allows you to potentially qualify for a higher loan amount and buy more house at the initial note rate. If you’re taking a 5-year ARM, you have to qualify at the initial note rate plus 2%.”

Mark Schulenburg, branch manager at Inlanta Mortgage

“I’m asking what their objectives and their goals are for their financing. Then we pinpoint the loan type that best meets their needs. Somebody who tells me with absolute certainty that they’re going to be out of their house in five-to-seven years, I recommend the 7-year ARM. Why do you want to pay a higher interest rate that won’t change for 30 years, if you’re not going to be in the loan for 30 years?”

Should you get an ARM?

If you missed 2021’s all-time low interest rates or the window earlier this year when they sat below 4%, an ARM could be an alternative way to lock in a historically low rate.

Choosing an ARM comes with potential access to below-market interest rates. And just like with an FRM, you can always refinance if rates drop again and you want to lock something in long-term.

Of course, going down this path will also depend on your risk tolerance and learning how adjustable rates work. If you’re ready or just curious whether an ARM is the right home loan for you, reach out to a lender today and get started.