After staying historically low for over a decade, mortgage interest rates are rising. The increase results from the Federal Reserve Bank’s effort to reduce inflation by raising the interest rates banks charge each other. When interest rates are rising, you may wonder if an adjustable-rate mortgage (ARM) is advisable for your homebuyers. So let’s take a look.
How does an ARM work?
An ARM has a fixed interest rate for a certain introductory period, followed by a floating or adjustable rate. The fixed and adjustable terms are expressed as a ratio. A typical example would be a 5/1 ARM, where the initial lower rate is locked in for five years but will adjust annually in response to current market conditions. Other fixed/adjustable terms could be 3/1 or 7/1.
ARMs often cap at how high the interest rate can go, both in an individual year and overall for the life of the loan. In addition, different payback options, such as principal and interest payments or interest-only payments, are available.
Who does an ARM appeal to?
ARMs appeal to many borrowers in a rising interest rate environment. They attract people who want to keep their monthly mortgage payments low to free up money for other things. An example would be a young couple buying their first home. They may want to keep their mortgage payment low to purchase furniture, save for having a baby, or achieve other goals.
When does an ARM make sense?
ARMs make sense if your buyer intends to own the house for just a few years, then sell or refinance before interest rates increase. However, if they are financing a “forever” home, an ARM does not make sense for the long term because of the potential they will be paying much higher interest down the road.
If you are advising your past buyers that own a home and have an ARM past its initial term, it is a good time for them to refinance into a fixed-rate loan before interest rates increase further. Then, if the rates go lower, they can refinance again to a lower fixed rate. However, be careful about refinancing too often because repeated loan closing costs can mount up and offset savings on the rate. So always consider the loan closing costs and ensure the numbers are worthwhile.
In a rising interest rate environment, an ARM is appealing in the short term but a risk when the rate adjusts. If you suggest that your homebuyers take out an ARM, be sure it has a cap on the increase in rate per adjustment year and for the life of the loan. Then they can keep the ARM if the rate cap works or refinance if a fixed rate loan makes more sense.
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