Since the start of 2022, the average 30yr fixed mortgage rate (as measured by the Mortgage Bankers Association) has skyrocketed 1.84 percentage points, from 3.52% to 5.36%. On a $250,000 mortgage, that represents an additional annual cost of around $4,600 in interest alone. Therefore, it comes as no surprise that many are looking for alternative mortgage options with a potentially more compelling interest rate profile for relief. High on that list is the Adjustable Rate Mortgage, better known as the ARM.
ARMs gained popularity in the late 1990s and peaked in the early 2000s, but fell out of favor for a time because of both a misplaced stigma associated with them as well as historically low rates on 15-year and 30-year fixed-rate mortgages. With interest rates back on the rise, it may be time to revisit this product and see if it makes sense for you.
Key Features
Structure
Most ARMs these days are hybrid in nature, meaning the rate is fixed for some period of time, after which it adjusts. ARMs can be structured in any number of different ways, but you will often see them structured as follows:
- 5/6 ARM – the initial rate is fixed for the first five years and will adjust every six months thereafter
- 7/6 ARM – the initial rate is fixed for the first seven years and will adjust every six months thereafter
- 10/6 ARM – the initial rate is fixed for the first ten years and will adjust every six months thereafter
- 7/3 ARM – the initial rate is fixed for the first seven years and will adjust every 3 years thereafter
- 10/3 ARM – the initial rate is fixed for the first ten years and will adjust every 3 years thereafter
Caps
This describes how much the rate can change at the various adjustment points. Some common caps include:
- 2/2/6 – the interest rate can go up by a maximum of 2% after the initial fixed period, 2% at each subsequent reset, but can never exceed at total 6% over the life of the loan
- 2/1/5 – the interest rate can go up by a maximum of 2% after the initial fixed period, 1% at each subsequent reset, but can never exceed at total 5% over the life of the loan
- 5/1/5 – the interest rate can go up by a maximum of 5% after the initial fixed period, 1% at each subsequent reset, but can never exceed at total 5% over the life of the loan
It is possible for interest rates to adjust down as well, but often there is a floor—usually the initial note rate—that will limit how low the rate can go
Index
The interest rate at each adjustment period is based on a previously determined index comprised of short-term rates. A few standard indexes that are often used are:
- SOFR – the Secured Overnight Financing Rate is an index based on highly liquid transactions where investors offer borrowers overnight loans backed by U.S. Treasury bonds
- CMT – the Constant Maturity Treasury represents the one-year yield of the most recently auctioned U.S. Treasury bonds
Margin
A constant value determined by your lender used in conjunction with the Index to calculate the interest rate at each adjustment period. Index + Margin = New Rate
Qualification
Unlike in the past, an initial low “teaser” rate is not used to determine borrower qualification. Rather, qualification is often based on the greater of the Fully Indexed Rate, and 1) the initial rate plus 2%, or 2) the initial note rate. ARMs with a shorter fixed period will normally use the initial rate plus 2% for qualification purposes.
Is an ARM right for you?
The biggest benefit of an ARM is that it typically has a lower initial interest rate than the fixed-rate equivalent. They do, however, have the added risk of uncertainty given the adjustable nature of the product. To make sure it is the right type of loan for you, there are certain factors to consider:
- How long you plan on having the mortgage.
- The time to break even versus a fixed-rate mortgage.
- This is determined by the difference in starting rate between an ARM versus a Fixed mortgage, as well as the incremental adjustments associated with an ARM.
- Whether you can financially withstand a worst-case rate adjustment
Adjustable Rate Mortgage vs Fixed Scenarios
Let’s see how the comparison between an ARM and a fixed-rate mortgage looks in 3 different scenarios. The first will be an “extreme” case in which the interest rate increases to the maximum at the first adjustment period, and then remains there for the life of the loan. The second will be a “normal” case in which the interest rate increases 1% at the first cap and then .125% at each subsequent cap until the lifetime cap of 5% is hit. The final will be the “optimal” case in which the rate never rises above the initial rate.
7/6 SOFR ARM (5/1/5 caps) vs 30yr Fixed – Extreme
Mortgage Amount: $200,000
30yr Fixed Initial Rate: 5.5%
7/6 ARM Initial Rate: 5.0%
In this scenario, the point at which the total amount of interest paid on both the fixed and ARM loans is the same (“breakeven”) occurs around month 95, indicted by the red arrow. If held to maturity, you would pay $131,485 more interest with an ARM.
7/6 SOFR ARM (5/1/5 caps) vs 30yr Fixed – Normal
Mortgage Amount: $200,000
30yr Fixed Initial Rate: 5.5%
7/6 ARM Initial Rate: 5.0%
In this scenario, the point at which the total amount of interest paid on both the fixed and ARM loans is the same (“breakeven”) occurs around month 126, indicted by the red arrow. If held to maturity, you would pay $94,360 more interest with an ARM.
7/6 SOFR ARM (5/1/5 caps) vs 30yr Fixed – Optimal
Mortgage Amount: $200,000
30yr Fixed Initial Rate: 5.5%
7/6 ARM Initial Rate: 5.0%
In this scenario, there is no breakeven as the interest paid on the ARM is better throughout the life of the loan. If held to maturity, you would pay $22,295 less interest with an ARM.
Summary
As you can see, there is clearly a role for the Adjustable Rate Mortgage in residential lending. However, each borrower must understand the full spectrum of benefits as well as potential risks when determining if it is the right product for you. At HomeFactor, all of our Home Mortgage Advisors are well versed in this type of analysis and have assisted hundreds of clients with finding the perfect loan for their situation. Call us today and see how we help you!
