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Is an Adjustable-Rate Mortgage a Smart Move in 2022?

Motley Fool - Tue Aug 2, 8:00AM CDT

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Mortgage rates have soared recently, and with the Federal Reserve's rate hikes and inflationary environment, it isn't too much of a surprise. As of the latest available data, the average interest rate on a 30-year fixed-rate mortgage is now 5.74% -- slightly below the recent peak near 6%, but nearly double the 3.01% average from a year ago. Combined with a roughly 20% gain in home values over the past year, this has made buying a home increasingly less affordable.

The surge in mortgage rates has also caused adjustable-rate mortgages, or ARMs, to come back into focus. For the past several years, with mortgage rates near all-time lows, there wasn't much benefit to obtaining an adjustable interest rate, and these loans were seldom used by home buyers. However, recent data shows that adjustable-rate mortgage demand has surged to its highest level since before the Great Recession, making up almost 20% of new loans by dollar volume.

To be sure, there are some good reasons for buyers to consider an adjustable-rate mortgage in the current housing market. But they aren't right for everyone. Here's a rundown of the advantages and drawbacks of using an adjustable-rate mortgage so you can make an informed decision.

Advantages of an adjustable-rate mortgage

Hands down, the biggest advantage of using an ARM to buy a home is cost. While 30-year fixed-rate loans have an average interest rate of 5.74%, the average initial interest rate on a 5/1 ARM (five-year initial rate period, adjusting every year thereafter) is just 4.19%.

To illustrate the difference this makes, let's say that you buy a home for $500,000 and put 20% down, so you need to borrow $400,000. Based on the average 30-year fixed-rate mortgage, you can expect a principal and interest (P+I) payment of $2,332. With an ARM, your monthly payment would be $1,954. In other words, using an ARM would reduce your housing costs by $378 per month, or more than $4,500 per year.

Buyer beware

In exchange for the lower initial rate, the downside is that you have little visibility into your future monthly payments. If you have a 5/1 ARM, your payment will stay the same for the first five years, but then can move up or down based on prevailing market conditions. In most cases, once your rate adjusts, it will be based on a benchmark interest rate and there will be a limit to how much it can adjust at once.

If interest rates end up falling back towards all-time lows, this could end up not being a big deal. Depending on your loan terms, it's certainly possible for ARM interest rates to adjust downward. But if rates stay elevated or rise even higher, your payment could start to rise significantly once your initial rate period is over.

Who should use an adjustable-rate mortgage today?

Adjustable-rate mortgages certainly make more sense now than they did a year ago, but they aren't right for all borrowers. While every situation is different, ARMs make the most sense for buyers who don't plan on owning the house for a long time or have reason to believe their qualifications will improve significantly before the initial rate period ends. For example, if you're just starting to establish credit and feel your score will be better in five years, or if you're purchasing a smaller starter home to live in for the next few years before having kids and upsizing, an ARM could be a smart choice.

Of course, an ARM can be a solid option for any home buyer looking to keep their monthly housing expenses low, but it's important to understand when and by how much the interest rate can adjust, and to be prepared to accept the risk of potentially rising future mortgage payments.

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