Risky adjustable-rate mortgages are making a comeback

With mortgage rates staying firmly put above 6% for the foreseeable future, homebuyers are on the hunt for savings. And they’re finding them in adjustable-rate mortgages, or ARMs.

The share of ARM applications reached 12.9% of total mortgage applications in September — the highest share since 2008, according to data from the Mortgage Bankers Association (MBA). At that time, 5/1 ARM rates averaged 5.66%, almost a full percentage point below the average 30-year fixed rate, the MBA said.

But despite their growing popularity, ARMs come with some risks and can sabotage a borrower’s ability to afford their home loan long term.

ARMs have a lower, fixed interest rate for the first few years of the loan, making repayment more affordable versus a 30-year, fixed-rate mortgage. After that period ends, the mortgage resets to a variable interest rate that changes annually or every six months (depending on the loan). That means monthly mortgage payments can go up or down, too.

Mortgage rates are generally expected to stay north of 6% in the coming year and, coupled with high home prices, are squeezing homebuyers’ budgets. The current national average 30-year fixed rate was 6.23% as of Nov. 26, according to Freddie Mac. On the flip side, the average 5/1 ARM rate is 6.07% as of Dec. 3, Bankrate data shows.

Using the current average interest rates above, here’s how much you’d save on monthly payments with an ARM versus a fixed-rate loan at various loan amounts.

At a 0.16% rate difference (6.23% fixed vs 6.07% ARM):

• $300,000 loan: Save $31/month ($1,865 over 5 years)

• $500,000 loan: Save $52/month ($3,108 over 5 years)

• $750,000 loan: Save $78/month ($4,661 over 5 years)

• $1 million loan: Save $104/month ($6,215 over 5 years)

Jennifer Beeston, executive vice president of national sales with Rate, says she rarely recommends ARMs to most borrowers.

“For conventional loans, I don’t think the benefit in rate is worth the risk,” Beeston said.

In most cases, ARM borrowers either refinance into a new fixed-rate loan or sell before their loan resets. But the math may not always add up in their favor down the road.

“What people don’t realize is that with an ARM, you are committing to having to requalify for that loan should you decide to keep the house for an extended period of time,” she explained. In most cases, it doesn’t work in borrowers’ favor to keep an ARM after the introductory rate period ends, especially in today’s elevated rate environment.

Qualifying for a new mortgage comes with another set of closing costs and considerations. For instance, what if you switch from a salaried position to self-employment and can’t qualify for a new loan? Or what if you get divorced and can’t prove your ability to repay on a single income? These are all questions to consider before taking on an ARM, Beeston said.

“If you’re doing something like house hacking — buying a house, living there for a couple years with 3.5% down, then turning it into a rental — you want to do a 30-year fixed at that owner-occupied rate,” Beeston said. “Second homes and investment properties are always going to have higher rates.”

During the Great Recession when borrowers owed more on their mortgages than their homes were worth after home values crashed, millions of homeowners were trapped in unaffordable home loans. If home values decline, you can’t refinance your way out of an ARM when it adjusts because you’ll lack sufficient equity. It can also make it harder for you to sell your home if values decline and you need to get out of an underwater mortgage.

Today’s ARMs typically have initial fixed terms of five, seven or ten years, so they don’t pose the risk of early payment shock that pre-2008 ARMs did, MBA chief economist Mike Fratantoni noted in a news release.

Beeston acknowledges ARMs can make sense for specific borrowers — particularly in the jumbo loan market where rate differences are more substantial.

“Half a percent on $100,000 is not worth the risk. Half a percent on $2 million? OK, let’s start talking about it,” she said.

The ideal ARM candidate plans to sell or refinance before the adjustment period, has stable high income, maintains low debt-to-income ratios and can absorb potential rate increases.

“If you have something on the horizon where it’s not an issue — you’re going to be making more, your job is secure — great,” Beeston said. “But if you’re [maxed on] qualifying right now and you have nothing on the horizon for a pay increase, it can be very dangerous.”

She warns that some lenders use ARM rates as bait without clearly showing actual payment differences or explaining the product’s mechanics. If a lender won’t show you the complete math or pressures you toward an ARM, that’s a red flag.

“When you’re talking to someone, it should be, ‘here are your options,'” she said. “You need to ask a lot of questions and make sure you can understand the product.”