You should be especially interested in this tactic if you don’t plan to live in the home for more than 5-10 years and those looking to purchase using an FHA loan with less than 20 percent down.
Mortgage rates have risen by over two percentage points since the start of the year.
The average 30-year fixed-rate mortgage has been hovering above 5% for more than a month, prompting some buyers to put their Columbus, Ohio home search on hold. While some buyers have bowed out of the market for now, others are exploring the alternative of what once seemed like an unlikely option: adjustable rate mortgages, or ARMs.
The cost of financing a home has risen so much, so fast that many buyers can no longer afford to buy a home with a traditional fixed-rate mortgage. The typical monthly payment on an average priced home with a 30-year fixed rate loan and 20% down is more than $600 higher now than at the start of this year – a 44% increase on principal and interest payments.
ARMs have come back into favor as they typically offer lower rates. While the average 30-year fixed-rate mortgage was 5.23% last week, a 5-year ARM was more than a percentage point lower at 4.12%.
ARMs offer a fixed rate for a set period – typically 5, 7 or 10 years – after which the interest rate resets to current market rates. A 5/1 ARM, for example, has a fixed rate for 5 years and then resets every year after that, while a 5/6 ARM is fixed for 5 years and then resets every 6 months. Loans reset based on a reference index like the Secured Overnight Financing Rate (SOFR) or the rate on short-term US Treasuries. There are also caps on how much a rate on an ARM can go up or down during each reset period and over the life of the loan.
While many home buyers are looking at ARMs as the best bridge until rates come back down and they’re able to refinance into a more competitive fixed rate, many simply don’t plan on living in the home for more than 5-10 years thus locking in the associated lower rates for the term of their intended ownership.
The Return of the ARM
For many old enough to recall the great recession and the subprime mortgage crisis that triggered the housing crash, the mere mention of ARMs can cause them to shudder. Many of the problematic loans issued during the subprime crisis were ARMs. But at that time, these loans were being offered without verifying a borrower’s income, with features that obscured the full mortgage payment or with interest-only or “teaser” rates. Sometimes the total cost of the loan increased because borrowers’ payments weren’t even covering the interest on the loan (this is also known as negative amortization). Many of these ARMs reset after only two years.
Because some of these loans were made at 100 percent of the property value, a prepayment penalty and transaction costs would cause a borrower to be unable to sell the home without being underwater – meaning they would owe more than the house is worth.
If a borrower needed to pay off the loan to get out of it by selling the home or refinancing, they weren’t allowed to without an absurdly high prepayment penalty. To be clear, it was an entirely different atmosphere than what we are looking at now.
Today’s ARMs require verification of a borrower’s income and typically a debt-to-income ratio of no more than 50%. They also offer better payment transparency by requiring lenders to provide a form outlining the closing costs and the costs of the loan over time. While interest-only ARMs and loans that reset monthly (rahter than once or twice a year) are still available, we suggest steering clear of these kinds of loans unless you are an experienced investor.
ARMs today not only offer a fixed-rate loan for a specified number of years, with a 7-year ARM serving as a fixed-rate loan for 7 years. There is also no prepayment penalty on an owner-occupied home so you can refinance out of it in two months, three years or whenever you want.
The typical 5 to 7 year schedule for an ARM resetting is in line with when many homeowners are likely to move or refinance or to do a home equity loan (to do a renovation, pay for their childrens tuition, etc) once they have accumulated some equity in their home.
Fixed Rate vs. ARM
While the overwhelming share of loans made over the past few years have been fixed-rate mortgages, ARMs are becoming more attractive in a higher rate environment. At the beginning of June just 8% of applications were for ARMs, according to the Mortgage Bankers Association.
While ARMs come with the risk of rates rising after the initial fixed term, they are more cost-effective in the near term.
A buyer purchasing a $390,000 home with 20% down that they expect to live in for 7 years will pay over $10,500 more during that time with a 30-year fixed rate loan at 5.23% than they would with a 5/1 ARM at 4.12% with the expectation that rates increase, according to numbers from Freddie Mac, which has a calculator borrowers can use to compare loans.
Payments on the fixed-rate loan would be about $200 more a month – at least until the rate of the ARM resets.
And don’t forget, you have the option of paying down more of the principal on the loan in those seven years by paying more than the monthly payment. Generally homeowners with higher mortgage rates will pay more in interest rather than principal for a longer time than those with lower interest rates.
Know the Risks
Still, even with shorter term savings, ARMs aren’t for everyone. For many people, a fixed-rate loan, even at 5% or above, may be a better fit.
If you plan on living in your home for more than 10 years, using an ARM to finance your purchase with the hope that rates will be lower at the end of the 10 year fixed term could be a risky bet. While general expectations are that rates will fall in the future and after inflation is brought down (the reason the Fed is increasing interest rates).
There is no guarantee that you will be able to refinance when the fixed term of the ARM ends. Thus if your income isn’t expected to rise much and your monthly cash flow is already tight, taking on the possible burden of higher mortgage payments when an ARM resets is certainly a risk.
What happens when the fixed rate period ends and rates are higher when the adjustment period begins leading to an increase in your monthly payment? What happens if you can’t afford to refinance? If you’re not willing to take on those risks, a fixed-rate is a safer solution.
Making the Best Decision
Regardless of the type of loan you use to finance your purchase, we recommend waiting to buy a home until you are out of debt, have at least three months’ worth of expenses in an emergency fund, and can make at least a 3.5% down payment. As a homebuyer, your goal should be to keep your house payment, including principal, interest, taxes, and insurance, below a third of your take home pay (even if banks will approve you for more). Click here for a Home Purchase Plan, Tips on Preparing to Buy a Home.
If you, or someone you know is considering Buying or Selling a Home in Columbus, or any of our other Central Ohio communities please give us a call and we’d be happy to assist!
The Opland Group Specializes in Real Estate Sales, Luxury Home Sales, Short Sales in; Bexley 43209 Columbus 43201 43206 43214 43215 Delaware 43015 Downtown Dublin 43016 43017 Gahanna 43219 43230 Grandview Heights 43212 Galena 43021 Hilliard 43026 Lewis Center 43035 New Albany 43054 Pickerington 43147 Polaris Powell 43065 Upper Arlington 43220 43221 Westerville 43081 43082 Worthington 43235