Adjustable-rate mortgages are making a comeback

Adjustable-rate mortgages, which got a bad name during the housing meltdown of the late 2000s, are gaining some traction again as would-be homebuyers face the highest rates in decades for fixed-rate mortgages.

As rates for the 30-year fixed-rate loan climb to levels not seen in 23 years, would-be homebuyers are looking for alternatives.

The most popular kind of mortgage — a 30-year, fixed-rate loan — reached an average rate of 7.67% last week, according to the Mortgage Bankers Association.

Meanwhile, the average rate for a kind of adjustable rate mortgage — a 5/1 ARM — dropped to 6.33% from 6.49%.

(Freddie Mac, which provides an average that CNN covers weekly, does not track interest rates for adjustable rate mortgages).

An aerial view of homes in a housing development on September 08, 2023 in Santa Clarita, California.

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“Mortgage applications increased for the first time in three weeks [last week], pushed higher by a 15% jump in ARM applications,” said Bob Broeksmit, CEO of MBA. “With mortgage rates well above 7%, some prospective homebuyers are turning to ARMs to lower their monthly payment in the short term amidst these high mortgage rates.”

Leading up to the foreclosure crisis, home buyers signed on for teaser rates that then reset and caused monthly payments to balloon above borrowers’ ability to pay them. Now, stricter regulations and more transparency have made ARMs less risky than they used to be.

But they are still a roll of the dice, because your rate will not stay the same for the life of the loan. And while it may go down, it could also go up.

ARMs offer a fixed rate for a set period — typically five, seven or 10 years — but after that, the interest rate resets to current market rates.

A 5/1 ARM, for example, has a fixed rate for five years and then resets every year after that, while a 5/6 ARM is fixed for five years and then resets every six months. Loans reset based on a reference index like the Secured Overnight Financing Rate 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.

Here’s why ARMs are getting a second look from some buyers.

Fixed rates will be ‘higher for longer’ as the Fed adjusts

Strong economic news over the past few weeks — a surprisingly robust jobs report and resilient consumer spending — has caused the Federal Reserve to suggest that its benchmark interest rate will remain “higher for longer.”

These economic data points “created shock waves through the market,” said Melissa Cohn, regional vice president at William Raveis Mortgage.

The geopolitical conflict following the Hamas incursion into Israel has led to higher oil prices, which act as inflationary, Cohn added.

DUMFRIES, VA - AUGUST 13: Single-family homes with ample yards are seen in Dumfries, Virginia, on August 13, 2023. (Amanda Andrade-Rhoades/For The Washington Post via Getty Images)

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Mortgage rates currently hover above 7.5%, and with another Fed meeting at the end of the month, “we need to expect rates to remain higher longer than we would like,” said Cohn.

While the Fed does not set mortgage rates directly, its actions influence them.

Mortgage rates tend to track the yield on 10-year US Treasuries, which move based on a combination of anticipation about the Fed’s actions, what the Fed actually does and investors’ reactions. When Treasury yields go up, so do mortgage rates; when they go down, mortgage rates tend to follow.

Some housing groups — including the Mortgage Bankers Association, National Association of Realtors and the National Association of Home Builders — wrote a letter last week urging the Fed to stop hiking rates.

Still, “rates won’t drop like a rock,” Cohn predicted, though there will be bubbles of rate drops, she said.

She recommends looking at five- and seven-year adjustable rates while keeping the monthly cost as low as possible and refinancing in 12 to 24 months.

“Hopefully, by the end of the year, [the Fed’s] rate hikes will really come through,” she said, meaning that inflation will come down and, in turn, mortgage rates will start decreasing next year.

Fixed rate vs ARM

While the overwhelming share of loans are still fixed-rate mortgages, ARMs are becoming more attractive in the current higher-rate environment.

The share of all loan applications that were adjustable-rate mortgages was 9.2% last week, according to MBA, the highest share since November 2022, when rates on 30-year fixed rate loans were also over 7%.

While ARMs come with more risks, they may be more cost effective in the near term for some buyers.

A sign outside a home for sale in Atlanta, Georgia, US, on Wednesday, Sept. 6, 2023. Home prices in the US climbed for a fifth month as buyers competed for deals in the least affordable market in decades. Photographer: Elijah Nouvelage/Bloomberg via Getty Images

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A buyer purchasing a median-priced $407,100 home with 20% down that they expect to live in for 7 years will pay over $14,500 more during that time with a 30-year fixed rate loan at 7.57% than they would with a 5/1 ARM at 6.33%, even if rates increase when it resets, according to numbers from Freddie Mac, which has a calculator borrowers can use to compare loans.

ARMs also often allow you to pay off more of the principal on the loan in those seven years. 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 rated loan, even at 7% or above, is better because of the set payments and the possibility to refinance to a lower rate, should rates drop.

Financial planners have some suggestions for homebuyers considering an ARM.

Kaylin Dillon, a certified financial planner in Kansas, said buyers should clear a couple of bars before getting into an ARM, including having extra cash to throw at payments on a monthly basis.

“I only suggest getting an ARM if you can afford to make excess mortgage payments large enough to pay off the loan in full before the fixed rate period of the loan ends,” she said. “This way, you have paid off your home at the lower interest rate without the risk of a ballooning interest rate at the end of the fixed period.”

Danny Crouch sits in his basement as he works from home in Arlington, Virginia, on May 25, 2023. The pandemic forced Americans to work from home. And now, more than three years on, employers are struggling to bring them back to the office. A third of employees in the US currently have complete freedom about where they work, compared with just 18 percent in France, according to a recent ADP study of 17 countries. (Photo by ANDREW CABALLERO-REYNOLDS / AFP) (Photo by ANDREW CABALLERO-REYNOLDS/AFP via Getty Images)

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If the rising rates have put your dream house out of reach, maybe it is time to take a breather from the housing market, said Jay Zigmont, a certified financial planner and founder of Childfree Wealth, based in Mississippi.

“You shouldn’t try to get fancy with your financing just to make your house ‘work,’” Zigmont said. He added that there is no guarantee that the value of the home will rise or that you will be able to refinance when the fixed term of the ARM ends.

If a buyer’s income is not expected to rise much and their monthly cash flow is already tight, taking on the possible burden of higher mortgage payments when an ARM resets is certainly a risk, said Cohn.

“What happens when the rate changes and you have to pay more each month? What happens if you lose your job and you can’t even afford to refinance? If you’re not willing to take on those risks, a fixed-rate is a better solution,” she said.