Many First-Time Homebuyers Could Use a Hand: Will an ARM Suffice?

With mortgage rates, home prices, and rents all remaining stubbornly high, many first-time homebuyers are stuck between a rock and a hard place when it comes to housing.

Renting can be cheaper in the short term (depending on the area), but at the end of the day, renters are building their landlord’s equity instead of their own.

So what can homebuyers do when affordability is a challenge in the marketplace? One strategy to reduce up-front costs and potentially get into homeownership sooner is to use a 5/1 adjustable-rate mortgage (ARM) instead of the traditional 30-year fixed-rate mortgage.

What Is an Adjustable-Rate Mortgage?

An adjustable rate mortgage is a loan that has a lower introductory rate than a traditional 30-year mortgage, but that rate can later adjust with the market.

There are a few variations of this loan type, but the most common is the 5/1 ARM. With a 5/1 ARM, the initial mortgage rate is fixed for five years and then adjusts to the market rate once per year for the remainder of the loan term.

The loan length is typically 30 years, so it adjusts for the last 25 years, if you keep the loan that long. It does not come with a balloon payment where you owe the remaining loan balance at the end of five years.

With a fixed-rate mortgage — as the name suggests — the rate is locked for the life of the loan.

Why Would Homebuyers Use an ARM?

There are several reasons someone might choose an adjustable rate over a fixed rate, but it all boils down to saving money — in the short-term, long-term or both.

The initial rate on an adjustable-rate mortgage is typically lower than a 30-year fixed rate.

Depending on current rates, the difference on a monthly payment between a fixed rate and an adjustable rate can be the difference between going over one's monthly budget versus having a small cushion each month. In other words, some homebuyers simply can’t afford a 30-year fixed-rate mortgage, and an ARM provides a backdoor to homeownership and long-term wealth creation.

But that’s just one reason to consider a 5/1 ARM.

Other reasons to choose an adjustable-rate mortgage include:

1. You plan to live in the home for fewer than five years, in which case you won’t have to worry about the rate adjusting higher.
2. You think your income will rise and you will be able to handle a potentially higher payment later on.
3. You plan to refinance within five years.
4. You will pay off the loan in five years (perhaps due to an inheritance or an expected source of funds).
5. You think rates will generally be the same or lower for as long as you have the home.

Aren’t ARMs Worse Than Fixed-Rate Loans?

When mortgage rates rise and ARMs become a more attractive option, there is frequently a whirlwind of opinions about this loan product.

That’s because ARMs played a role in the mid-2000’s housing bubble that famously popped in 2008.

However, we’re in a much different mortgage environment these days. Lending practices are stricter, and borrowers are more qualified than they were 15-to-20 years ago. And some of the more exotic adjustable-rate products that fueled the mid-2000’s bubble are no longer offered by reputable lenders.

Today, the adjustable-rate mortgage is best described as a tool. Not Thor’s hammer that can pound any mortgage into submission, but a regular tool that performs well under the right circumstances.

ARMs Come with Guardrails

There are also guardrails in place that prevent adjustable rates from rising too far or too fast.

These guardrails are known as caps. They act as limiters that literally place a cap on how high the rate can rise.

For example, an ARM with a 5% lifetime cap can only rise 5 percentage points from the initial rate at a maximum. So an initial rate of 4% could never go above 9%.^†

Additionally, there is an initial adjustment cap that limits the first adjustment in year six of the loan. The subsequent adjustment cap limits how much the rate can rise in any given year.

2/2/5 ARM Cap example:

• The rate can’t rise more than 2% in the first adjustment
• The rate can’t rise more than 2% in any given year
• The rate can’t rise more than 5% from the introductory rate

The Right Tool for the Time

For some homebuyers — especially first-time homebuyers on the edge of being able to qualify for a mortgage — an adjustable rate mortgage may be the right tool to achieve homeownership in today’s competitive housing market.

As mortgage rates continue to shift, more homebuyers may find themselves reaching for this tool to accomplish their goals.

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