Over the last few years, it has been an extreme seller's market characterized by low inventory and rising home prices. Home sellers have been in the driver's seat.
Most homes listed for sale have experienced bidding wars, with sales prices far exceeding the asking price. It has been the ultimate nirvana for home sellers. Not so much for home buyers who have seen their dream home become more and more expensive.
Home buyers have been afforded the luxury of ultra-low interest rates, so attractive mortgage rates have absorbed some of the pain of high home prices.
In real estate, all good things eventually come to an end. Markets eventually shift one way or another.
Unfortunately, mortgage rates have risen now to the point where some buyers have been locked out of the market.
To continue to search for their dream home, they have been forced to consider an adjustable-rate mortgage. Adjustable rate mortgages (ARM) offer lower interest rates than fixed-rate mortgages but are also riskier for borrowers.
At a moment's notice, an adjustable-rate mortgage can shoot upwards and become a less affordable financing alternative.
Let's look at the downsides of an adjustable-rate mortgage so you know what you're getting into.
An adjustable-rate mortgage (ARM) is a type of mortgage that allows the borrower to lock in a rate for a certain period of time.
The most common period for an adjustable-rate mortgage is 3, 5, 7, or ten years. In other words, when the terms of the mortgage interest rate can change. Variable-rate mortgages are still typically amortized over 15-30 years.
Usually, the shorter the adjustment period, the more attractive the interest rate you will receive.
The downside to this type of mortgage is that if interest rates rise during the loan term, the monthly payment may increase significantly.
Additionally, if market conditions change and the interest rate on ARMs rises above the rate offered at origination, borrowers may struggle to keep up with monthly mortgage payments.
Adjustable rate mortgage programs will have a stated period of time where the interest rate will be fixed. When the fixed time frame ends, the adjustment period starts.
Once the variable rate period starts, it will change based on a benchmark rate stated in the loan.
For example, if you have a three-year adjustable-rate mortgage, the interest rate will remain fixed for those three years. The interest rate can and will change at the end of three years.
Many factors contribute to the interest rate you will pay on your mortgage. These include your credit score, the amount of down payment you make, and whether or not you are a first-time home buyer.
The amount your interest rate changes for an adjustable-rate mortgage largely depends on broader financial and economic conditions.
As previously mentioned, the rate used for an adjustable rate loan will be tied to a benchmarked reference point.
It is commonly tied to the U.S. Treasury rate. When the benchmark rates rise, so does the interest rate with your variable rate loan.
However, there are "caps" on how much your interest rate can increase in a year. Typically, the rate is capped at 2 percent.
So if you started with a 4 percent loan, it could not go any higher in one year than 6 percent.
There is also a lifetime cap on interest rates as well. Most of the time, the cap will be set at 6 percent, although there are some programs where it could be lower.
So using the same 4 percent example, the highest the interest rate could rise over the life of the loan is 10 percent.
Keep in mind that market conditions will dictate whether interest rates go up or down.
Two common types of borrowers whose adjustable mortgage rates make sense are those who are transient and those who need a lower rate to qualify to purchase a home.
An adjustable-rate loan makes sense when you are constantly being relocated for work and know you won't stay in one place for a long time.
If you know, you'll be in a property for an extended period, a fixed-rate mortgage would offer more financial stability.
Some borrowers need a lower rate to become first-time buyers or even purchase a second home. They may even look at some of the lower-income housing choices.
One of the significant advantages of adjustable-rate mortgages is they typically have lower initial rates.
There are some potential downside risks with an ARM. Your mortgage interest rate could increase, causing your monthly mortgage payments to go up.
If you've been living on a fixed income, it could impact your lifestyle from a financial standpoint.
When the interest rate on your ARM changes during your loan term, you could owe more money than you originally planned.
If you have a low down payment and the real estate market faces a downturn, you could owe more money than your house is worth.
When the market value of your home falls below your original purchase price, you may end up losing money because your loan balance will be greater than what you paid.
This could happen even if the interest rate on your ARM remains unchanged – if house prices fall sharply enough, you may owe more than what is still owed on your original mortgage balance.
When you need financial stability, going with an adjustable rate is not the way to do it. On the other hand, if it is the only way to get into a home, it may make sense.
In such cases, it will make sense to monitor interest rates, and if they drop, you can refinance into a fixed-rate loan.