Rising mortgage rates: Is now the time for ARM loans?

ARM loans can be a better deal when rates are rising

ARM loans are an invisible part of the mortgage marketplace, but maybe that’s about to change.

Since 2009 annual mortgage rates have been below 5 percent, and demand for adjustable-rate mortgages (ARMs) has been in the single digits. Ellie Mae reports that in December 2017, ARMs comprised just 5.6 percent of the marketplace, up from just 3.9 percent in November 2016.

Why the new interest in ARM loans?

There are few financial products which are easier to understand or a better deal for borrowers than the plain fixed-rate mortgage. Get a fixed-rate mortgage – an FRM – and you’ve locked in a mortgage rate for as long as 30 years. You have a hedge against inflation and higher mortgage rates.

How ARM rates work

If you financed during the first week of January 2018, you could get prime fixed-rate financing at 3.95 percent (according to Freddie Mac). Skip forward to mid-February, and the going rate was 4.38 percent. That’s a difference of .43 percent in just six weeks. If you have a $200,000 mortgage, that’s almost $860 in extra interest during the first year.

What can you do to keep monthly costs low?

One approach is simply to borrow less. As interest rates rise, home prices increases can slow, and – maybe – even decline.

According to Lawrence Yun, chief economist with the National Association of Realtors – each .10 percent mortgage rate increase reduces home sales by 35,000 units. Less demand can mean lower home prices, meaning you may not need to borrow as much.

Alternatively, you may want to get off the comfy 30-year fixed bandwagon and search out other products.

ARM loans and rising mortgage rates

For example, consider ARM financing. In mid-February, according to the Mortgage Bankers Association, conforming loans were priced at 4.57 percent. At the same time, 5/1 ARMs were priced at 3.74 percent.

For a $150,000 mortgage, an FRM borrower will pay $766.28 for monthly principal and interest. An ARM borrower will pay $693.82. That’s a difference of $72.46 a month, or $870 a year.

3 questions to ask when considering an ARM

Why do lenders offer an ARM discount? The issue is “interest rate risk.” If you have a 4 percent fixed-rate mortgage, and market rates go up to 5 percent, the lender is “losing” 1 percent. Rates for an ARM can go up or down, and this protects lenders.

To make ARMs attractive, lenders offer three benefits for borrowers.

• First, there is a lower introductory rate. With a 5/1 ARM, the starter rate lasts five years, and then the rate can move up or down.
• Second, because the introductory rate is lower, it can be easier to qualify for financing.
• Third, there are borrower protections built into ARMs. Such protections include annual and lifetime rate increase caps.

ARMs come with introductory periods ranging from three to ten years. In general, the shorter the initial fixed period, the lower the interest rate.

ARM loans and tenure

Usually, when borrowers compare ARM loans and fixed-rate financing there are a number of points to compare. What is the fixed interest rate? What is the ARM start rate? How long does the start rate last? What are the ARM rate caps? If rates go down, what is the minimum (floor)?

However, the most important question is this: How long do you expect to stay in the house?

What's better in 2018? A 5/1 ARM or 15-year fixed?

The reason to consider the length of ownership – what’s known as “tenure” – is that it can very much influence your ARM strategy.

• Freddie Mac says in the third quarter the typical loan was outstanding 6.1 years before refinancing.
• ATTOM Data Solutions says “U.S. homeowners who sold in the third quarter had owned an average of 8.19 years.”
• The typical 2017 seller, said the National Association of Realtors, “was in the home for 10 years before selling — matching the all-time high set both in 2014 and a year ago. Prior to 2009, sellers consistently lived in their home for a median of six years before selling.”

A lot of people view ARMs as risky when compared with fixed-rate financing because rates can go up. However, if ARMs are only outstanding for as long as the start rate is in effect, they may actually represent a lower rate and no additional risk. And if the ARM is outstanding a few years after the start rate ends, the annual caps may prevent outrageous rate increases.

Longer ARMs

While the most popular ARM is the 5/1, and the 3/1 offers the lowest rate, a 7/1 ARM or 10/1 ARM can provide lower costs and greater security for many borrowers. What happens later in the ARM loan term doesn’t matter if the house sells or the owners refinance first.

If your goal is to keep a mortgage for the long term than fixed-rate financing can provide rate stability. If you expect to move in seven to ten years then take a look at ARMs. They may be a very plausible mortgage option.

What are today’s mortgage rates?

Current mortgage rates are at four-year highs, and that’s why more borrowers are looking at ARMs. However, rates are still historically highly-affordable.

In addition to exploring ARMs to get a better mortgage rate, you can shave up to .5 percent from your rate simply by shopping carefully and comparing multiple mortgage quotes.