Why Adjustable-Rate Mortgages Are Bad News Right Now

Posted on November 23rd, 2020

With mortgage interest rates as low as they are at the moment, you may be looking beyond fixed-rate options if you’re in the market to purchase a home or refinance an existing home loan.

After all, while 30-year fixed mortgage rates are hovering around 2.75%, some adjustable-rate mortgages are in the very low 2% range.

This can certainly push your monthly mortgage payment even lower, especially if you have a jumbo loan amount. But is it worth the risk?

Is It Worth Going After an Even Lower Mortgage Rate?

There’s no question that fixed mortgage rates are very attractive right now
But there are still other home loan programs out there
Some savvy homeowners might be looking at ARMs because there’s an opportunity to save even more money
It might be possible to pay less interest with the safety of a fixed rate for 5-7 years

They say not to look a gift horse in the mouth. And with mortgage rates setting 13 record lows so far this year, why look any further than a fixed-rate mortgage?

Well, because it’s possible to obtain an even lower rate if you go with say a 5/1 ARM instead, which is fixed for the first five years before becoming annually adjustable.

That means there’s relative safety there if you don’t plan on sticking around for long, or have the flexibility to pay off your home loan in full if interest rates do rise.

For instance, if you sell your home or refinance before those five years are up, you could save a good amount of money over those 60 months.

Let’s look at a quick example to illustrate:

30-year fixed @ 2.75%: $1,224.72
5/1 ARM @ 2.25%: $1,146.74

On a $300,000 loan amount, the difference in monthly mortgage payment is roughly $78 a month.

Over five years, that’s roughly $4,680 in savings. Not an incidental amount by any stretch, but there has to be a catch, right?

Well, we’re in a unique spot at the moment. Mortgage rates are pretty much in unprecedented territory.

They’re absolutely rock-bottom historically, having fallen to record lows in what I assume is also a record 13 times so far this year.

So looking a gift horse in the mouth might not be the smartest move.

Mortgage Rates Have Nowhere To Go But Up

ARMs generally make sense when interest rates are high
Because there’s a better chance of a bigger discount relative to a fixed-rate loan option
But the spreads between FRMs and ARMs are pretty narrow right now
And if rates are at record lows they’ll probably rise in the near future

Unfortunately, the general consensus is that mortgage rates have nowhere to go but up. That’s mostly not debatable, though I wouldn’t be surprised if they do move lower this year and next.

However, if and when they do rise, how much will they go up? That’s the big question.

They could rise quickly if there’s a COVID-19 vaccine and the economy gets back on track in a hurry, which is a must eventually, right?

So if you reside in a home that you plan on living in for the foreseeable future, taking a chance on an ARM right now may burn you a few years from now.

Sure, you may save money over the next 5+ years, but after that you may find that mortgage rates have surged.

At that point, when your ARM is set for its first adjustment, it will most likely adjust higher. And potentially a lot higher.

And let’s face it, five years can go by in the blink of an eye.

The other problem with ARMs right now is that they just aren’t that cheap.

The spread between a 30-year fixed and ARM is marginal at best with many lenders.

Many aren’t even advertising their ARM rates, and are instead directing everyone to a 15-year or 30-year fixed.

Of those that are advertising ARM rates, what I saw wasn’t all that impressive, especially on conforming mortgages.

We’re talking a quarter to three-eighths of a point lower, so maybe 2.375% instead of 2.75%. Others weren’t even offering a discount.

On jumbo home loans, you might see a bigger spread, but historically they are still very tight because fixed rates are so low at the moment.

If 30-year fixed mortgage rates were in the 4-5% range, you’d maybe see a difference of .75% to a full percentage point with some lenders.

In other words, there isn’t much of a discount on ARMs right now, and you’re taking a relatively big risk with rates being at record lows.

Don’t Choose an ARM If You Can’t Handle the Higher Monthly Payment

If you do want a slight interest rate discount you can go with an ARM
Just be sure you can make the larger monthly payment once it adjusts in the future
Otherwise you could be asking for trouble if rates rise over the next several years and you still own your home
Chances are the fully-indexed rate on your ARM will be higher even if rates remain steady, which at best will require a refinance

If you can’t handle the interest rate uncertainty of an adjustable-rate mortgage, and don’t know if you’ll be selling before the adjustable period ends, an ARM probably isn’t a good choice right now.

Once interest rates rise, you’ll be stuck with a larger monthly payment, or you’ll be forced to refinance to cut your losses.

And even a mortgage refinance may be out of the question if you’ve got income restraints (debt-to-income ratio) or some other unexpected life event transpires.

It’s never an absolute guarantee that you’ll be able to sell your home (for the right price) or refinance in the future.

So you really have to be prepared for what’s next once the ARM’s initial fixed period comes to an end.

Ultimately, ARMs aren’t coming with a very large discount at the moment, so you’ll need to sit down and decide if a rate .25% to .375% lower is worth the stress over the next several years.

If you’re super confident you’ll move, or be able to refinance no matter what takes place, you can take a chance, but there are probably better times to do so.

Lastly, if you are set on an ARM, be sure to put in a lot of time shopping around because ARM rates are super variable from one lender to the next, much more so than fixed rates.