If you have been shopping for a loan in June 2022, you may have noticed rates have risen. In fact, the average 30-year fixed rate for conventional loans has just about doubled since the lows of January 2021.
According to this chart from FHLMC, the 2nd largest purchaser of agency mortgages, rates went from 2.74% in 1/21 to as high as 6.28% in mid-June of 2022. That is a whopping 129% increase. This is enough to discourage millions of home buyers. It has also put a huge dent in the mortgage refinance business.
What are the alternatives as we move forward? At least while the Fed’s policy of raising rates to curb inflation continues. The good news is that there are alternatives to consider – Adjustable Rate Mortgages (ARM).
What Are ARMs and How Do They Work?
It has been some time since this type of mortgage has had any significant attention. There is probably a lot of misinformation on these loans. Most of it comes from those who may have had a bad experience with them during the last housing crash. Adjustable Rate Mortgages are a tool like any other tool. Much like a hammer; In the hands of the right person, it can be used to build a house. In the hands of the wrong person, it can be used to destroy a house. The tool itself is neither good nor bad.
All adjustable-rate mortgages have some common elements. To begin with, the rate will adjust at some point. We will review when and how much they will adjust shortly.
These mortgages all have a period of time when they are fixed. Then they adjust at a predetermined periodic time frame. They all have caps on the maximum they can adjust at the first adjustment, the periodic adjustments, and a lifetime cap. This may sound more complicated than it really is. Just hold on and we will look at some actual numbers you can relate to a little bit easier.
Types of Adjustable Rate Mortgages
There is a wide variety of ARMs. The difference mostly is how often they adjust and what index and margin they use. Having said that, there are only a small number of ARMs that are actually being used right now. We will focus our discussion of ARMS on those that you may actually consider.
The 10/1 ARM is probably the next best thing to the 30-year fixed mortgage for a few reasons. To begin, the initial rate on these loans is about ½ to ¾ of a percent lower than the 30-year fixed mortgages. This can be the difference between qualifying for that new house or not qualifying.
The next most attractive feature is the initial period that the rate will remain fixed — 10 years. That is the 10 in the 10/1 ARM name. The second number, the 1, is how often after the first ten years, the rate will adjust; once a year.
This ARM will give you the security of having a fixed rate for ten years. It will also have the reassurance that your rate will then adjust only once a year. Considering that the average holding time for a mortgage is somewhere between 5 and 7 years, this is ample time for you to have the security of a fixed rate before you refinance or move.
The 5/1 ARM is the 2nd most popular ARM product in the market. It has an initial fixed period of 5 years and it also adjusts once a year after the initial period.
Those that choose this shorter fixed period mortgage are people who plan to only have this loan or this home for a short time. They also have a higher tolerance for risk in case their plans change and end up keeping the home for more than 5 years.
Keep in mind that just because you keep the home for an extended period of time, it does not mean you have to keep the mortgage. You can refinance literally any time. There is no required minimum period of time you have to keep a mortgage. Thanks to laws enacted by the efforts of consumer protection watchdogs, there are no pre-payment penalties on owner-occupied mortgages anymore. You are not going to get swindled if you decide to refinance.
The shorter fixed-rate period ARMs also tend to have a slightly lower rate than the 10/1 ARMs.
You may come across other ARMs such as 7/1 or 3/1 ARMs as well. Both of those seem to be out of favor in the market at this time.
How Often and How Much Can These Mortgages Adjust?
This is of course one of the most important and pressing questions about ARM products. Adjustable Rate Mortgages have the following features that determine the amount of adjustment possible, and also the maximum that the adjustment can be.
- Index – The index is the base for the adjustment of the rate. Most ARMs use the SOFR Index.
- Margin – The margin is the amount that is added to the Index to calculate the possible maximum adjustment to the rate at the pre-determined (reset) periods.
- Caps – The maximum the rate can increase at the pre-determined adjustment (reset) periods.
Let’s take a look at a practical example so this makes sense: A 10/1 ARM with a start rate of 4.5%, a margin of 2.5%, and caps of 5/2/5, tied to the SOFR index. This is a very common set of features with this type of mortgage. The rate will be fixed for 10 years at 4.5% and will adjust once a year thereafter.
The caps in the 5/2/5 limits are as follows:
- First adjustment cap: 5% (The most that can be added to the initial note rate of 4.5% during the first adjustment)
- Cap on all future adjustments: 2% (The most that can be added on top of the current rate at the time of future adjustments)
- Lifetime cap: 5% (the maximum that can ever be added to the initial note rate of 4.5%)
So, let’s say the SOFR index is 3% at the time of first adjustment (after 10 years). You take the 3% and add the margin of 2.5% for a total of 5.5%. This is what is known as the “Fully Indexed Rate”. In this particular scenario, the rate would be adjusted to 5.5% on the 11th year and would remain there for the next 12 months. That’s fairly realistic and the outcome is not bad at all.
By the time that 11th year comes around, rates will either improve enough to refinance or you will be thinking of moving to a different home, perhaps both.
As of mid-2022, the inflation rate continues to worry the public policymakers on rates. The Fed has made it clear they will continue to raise rates aggressively to curb inflation.
This means you are likely to see even higher mortgage rates. The need to consider alternatives to the high rates will also increase. You are also likely to see additional versions of ARMs come on the market.
As was mentioned previously, there is no need to vilify these mortgage products. They can help you save money in the short term. If you plan accordingly for the future, you will know the maximums you may have to deal with. If it all passes muster, these alternatives may make a lot of sense.
Choose wisely and make informed decisions.