Adjustable-rate mortgages are making a comeback.
With interest rates surging, more buyers are turning to ARMs, which offer lower initial rates than fixed-rate loans. However, after a certain period, the rate on the ARM adjusts to reflect current market conditions.
"You have double the number of borrowers out there applying for ARMs in the last four months because of how quickly the rates have come up," said Joel Kan, associate vice president of economic and industry forecasting at the Mortgage Bankers Association.
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The rate for a 30-year fixed rate mortgage is 5.41%, according to Mortgage News Daily. Meanwhile, the rate for a 5/1 ARM is 4.38%. The ""5" means the rate is fixed for five years and the "1" means it would then readjust once every year for the remaining life of the loan.
"Clearly people are looking for other options when it comes to financing their home, because they are competing with other borrowers and they are likely looking to secure the home that they want, given how tight housing inventory is," Kan said.
How ARMs work
There are different timeframes available for the fixed part of the loan: generally three, five, seven and 10 years. The readjustment period could be one year or six months, which would look like 7/1 or 7/6, respectively, for a seven-year ARM.
There are also caps on the interest rate, meaning there is a maximum amount the rate can increase or decrease each time, as well as a lifetime maximum cap. For instance, if you have a 5% lifetime cap on your 5/1 ARM, your 4.38% rate could eventually wind up at 9.38%.
That's why it is so important to understand the specific terms of the loans you are considering.
"Using an adjustable-rate mortgage can make sense in some situations, but it's a more sophisticated mortgage product," said Danielle Hale, chief economist at Realtor.com.
"Buyers considering it will want to make sure they understand the pros, cons and risks."
Weighing your options
ARMs aren't nearly as popular as they were during the subprime mortgage crisis in mid-2000s, when credit standards were lax and a lot of borrowers ended up in trouble. These days, the credit standards are a lot higher and underwriting is extremely tight, Kan said.
"We are not looking at the same kind of risks as we did then," he said.
That said, if you take out an adjustable-rate mortgage, you risk ultimately ending up with an interest rate that is substantially higher than a fixed-rate loan.
Therefore, if you are considering an ARM, think about how long you plan to stay in the home.
"It might make sense for people who are looking at a short timeline," said certified financial planner Diahann Lassus, managing principal at Peapack Private Wealth Management in New Providence, New Jersey.
"They want to buy a house but are probably moving in three to five years," she added. "If they can lock into a five-year ARM, that could help them reduce their cost and sell in five years before the interest rate recalculates."
It may also make work for someone who will pay off the loan in a relatively short period of time, like those who wait to sell their previous home and then use the proceeds for the new home, said Lassus, a member of the CNBC Financial Advisor Council.
However, remember that plans can change or you may not be able to sell your home when you want to. If you wind up sticking with the loan past its initial fixed rate and the rate goes up, you'll wind up with increased monthly payment.
"Be sure you know how much higher the interest on your loan can go and what that means for your monthly payment and its impact on your budget," Realtor.com's Hale said.
Of course, ARM rates can also decline if mortgage rates go lower.
"Typically, when mortgage rate declines are expected, adjustable-rate mortgages are offered at less of a discount, and very rarely even a premium, to fixed-rate mortgages," she explained.
Lassus advises anyone planning to stay longer than the term of the fixed rate on an ARM to stick with traditional fixed-rate loans.
Of course, the prices of homes are also high, which is making affordability a factor for many. For those who can wait, be patient and wait for the right opportunity, she advises.
Also, bear in mind that fixed-mortgage rates around 5% are still reasonable, historically speaking, Lassus pointed out.
"We have lived in this really, really inexpensive mortgage period and that has changed our perspective," she said.
"It is going to take a while to get used to the higher mortgage rates and what that means."
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