ARMs offer tempting mortgage savings, but there’s a risk

A new study from Redfin shows that homebuyers could save an average of $260 per month if they purchase a home now with an adjustable-rate mortgage rather than a traditional fixed-rate loan. That would mean savings of more than $15,000 over the first five years of the loan.

It’s a tempting number that explains why so-called ARMs are in big demand. Earlier this month it was reported that demand for ARMs had reached a 14-year high amid rising interest rates that have made standard mortgages far more expensive.

With ARMs, homebuyers can obtain lower rates for a fixed term of five, seven or 10 years, after which the rate will change depending on market conditions. ARMs are fully underwritten, the same as fixed-rate mortgages, and also require a down payment.

A 5/1 ARM would mean that the interest rate is fixed for the first five years of the loan, and adjusted each year afterwards for the remainder of the loan, which is usually 30 years. Some ARMs only reset after seven years, and 10-year ARMs are also common. They’re different from the fixed-rate mortgage, which stays at the same interest rate for the entire lifetime of the loan.

While ARMs can provide significant savings, they also come with risks. If interest rates rise substantially, borrowers can be left with much higher payments once the rate resets. In addition, many ARMs come with significant fees if borrowers want to pay off the loan early or refinance.

“Adjustable-rate mortgages can work really well for home buyers who plan to stay in their home for less than five to 10 years and have the means to cover higher payments when the loan resets,” Arnell Brady, a senior loan officer at Bay Equity Home Loans, told Redfin. He noted that up to 30% of his clients are now requesting ARMs.

The 30-year fixed-rate mortgage averaged 5.25% last week while the 5-year ARM averaged 4.08%, Freddie Mac reported.

One year ago, ARMs were almost non-existent as the interest rate sat at just below 3%. Because of the increases this year, many borrowers who signed contracts have suddenly found themselves priced out of the homes they were planning to buy, faced with increases of hundreds of dollars on their mortgage payments.