Believe it or not, adjustable rate mortgages are back. These variable rate mortgages may sound like a good deal, but they’re also a great way to burn yourself.
If you’re unfamiliar with adjustable rate mortgages, it may be because they were extremely unpopular for about fifteen years, thanks to their role in the 2008 financial crash.
At the time, banks offered borrowers adjustable-rate mortgages with extremely low introductory rates, even though many of these borrowers, under various circumstances, could not afford their monthly mortgage payments. When interest rates went up, people started missing payments. Many homes went into foreclosure, several banks and investment brokers failed, and the rest ̵1; as they say – is history.
Today’s adjustable rate mortgages are a much safer option for both banks and consumers, thanks to federal legislation that prevents undercutting in lending. But just because these new and improved mortgages are better for borrowers doesn’t mean an ARM is the best choice for you.
If you are considering getting an adjustable rate mortgage, read this first. Then ask yourself if you still want to take out a mortgage with a variable interest rate.
What is an adjustable rate mortgage?
Adjustable rate mortgages, also known as ARMs, allow homeowners to take out a mortgage at a lower interest rate than they might have gotten with a fixed rate mortgage – for a limited time. When the original rate expires, the rate charged by your lender is automatically adjusted at periodic intervals based on a pre-determined index.
Essentially, your ARM rate starts to shift, and not necessarily for the better.
“Adjustable rate mortgages are the sophisticated person’s home loan bet,” says Lawrence Delva-Gonzalez, a federal accountant and financial literacy educator who runs The Neighborhood Finance Guy. “If interest rates go up, your mortgage rate will go up and so will your monthly payments. If prices go down, your payments will go down too.”
Are adjustable rate mortgages a good idea right now?
If you are considering an adjustable-rate mortgage in 2022, you need to think long-term. You must also consider not only your own financial health, but the health of the American economy.
People who bought homes during the pandemic were able to take advantage of historically low interest rates, and many homeowners with good credit were able to get 30-year fixed-rate mortgages for between 2% and 3% APR. People applying for mortgages right now are likely to pay closer to 7% APR. And thanks to our current inflationary environment, it’s likely that we’ll see mortgage rates rise before they start to fall again.
“It may be a while before we get back to 2% mortgage rates,” Delva-Gonzalez explains. “The Federal Chair hinted back in February that it took over 20 rate hikes to fuel inflation in the late 1970s and early 1980s. It could take another 20 rate hikes this time around.”
In other words, be careful about taking out a variable rate loan right now. If you apply for an interest rate variable loan, you may pay less interest today. But if the Federal Reserve continues to raise interest rates, you could be stuck paying a lot more than you expected.
“It’s going to take a lot to get back to normal,” says Delva-Gonzalez.
How can you use an adjustable rate mortgage to your advantage?
If you know what you’re getting into, you can get a lot out of a fixed-rate mortgage. The trick is to plan ahead and get as much of your mortgage paid off as possible before your interest rates start to shift.
“The big idea with mortgages is to pay them off earlier,” explains Delva-Gonzalez. “If you do it in a shorter time, you save interest regardless of which loan you use.”
If you’re considering an ARM, Delva-Gonzalez suggests budgeting for a higher interest rate than the teaser rate you might be offered initially. This gives you a surplus of cash, plus some wiggle room.
“Use the excess for additional payments toward the principal,” says Delva-Gonzalez. If your interest rates go up, your excess savings can help you pay your monthly mortgage without having to cut back on other expenses. If your interest rates go down and you keep making the same monthly payments, your mortgage can be paid off that much faster.
That said, if you can afford to pay a higher interest rate right now, you may want to consider a fixed rate mortgage instead of an ARM. “I’m a bigger fan of keeping the numbers simple with a fixed-rate option,” explains Delva-Gonzalez. “These changes up or down only complicate budgeting in the short and long term.”