If you’re considering a variable rate mortgage, consider the risks

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As interest rates rise, it may be tempting for homebuyers to explore variable rate mortgages.

The appeal of an ARM, as it is called, may be the lower initial interest rate compared to a traditional 30-year fixed rate mortgage. However, this rate can change down the road – and not necessarily in your favor.

“There’s a lot of variability in specific terms as to how much rates can go up and how quickly,” said certified financial planner David Mendels, director of planning at Creative Financial Concepts in New York. “No one can predict what rates will do, but one thing is clear – there’s a lot more room upside than downside.”

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Interest rates remain historically low, but have risen in a housing market that already poses affordability challenges for buyers. The median list price of a home in the United States is $405,000, up 14% from a year ago, according to Realtor.com.

The average fixed rate on a 30-year mortgage is 4.67%, down from less than 3% in November and the highest since late 2018, according to the Federal Reserve Bank of St. Louis. By comparison, the average introductory rate on a popular ARM is 3.5%.

With these mortgages, the initial interest rate is fixed for a fixed term.

After that, the rate could go up or down, or remain unchanged. This uncertainty makes an ARM a riskier proposition than a fixed rate mortgage. This is true whether you are using an ARM to buy a home or to refinance a loan on a home you already own.

If you’re exploring an ARM, there are a few things to be aware of.

To begin, consider the name of the ARM. For a so-called 5/1 ARM, for example, the introductory rate lasts for five years (the “5”) and after that the rate can change once a year (the “1”).

Don’t just think of a 1% or 2% increase. Could you cope with a maximum increase?

David Mendels

Director of Planning at Creative Financial Concepts

Some lenders also offer ARMs with an introductory rate of three years (a 3/1 ARM), seven years (a 7/1 ARM), and 10 years (a 10/1 ARM).

In addition to knowing when the interest rate might start to change and how often, you need to know how much that adjustment might be and what the maximum rate charged might be.

“Don’t just think in terms of a 1% or 2% increase,” Mendels said. “Could you handle a maximum raise?”

Mortgage lenders use an index and add an agreed percentage point (called the margin) to arrive at the total rate you pay. Commonly used benchmarks include the one-year Libor, which stands for the London Interbank Offered Rate, or the weekly one-year Treasury bill yield.

So, if the index used by the lender is 1% and your margin is 2.75%, you will pay 3.75%. After five years with a 5/1 ARM, if the index is at, say, 2%, your total would be 4.75%. But what if the index is at, say, 5% after five years? Whether your interest rate can increase that much depends on the terms of your contract.

An ARM usually comes with caps on the annual adjustment and on the term of the loan. However, they can vary from lender to lender, making it important to fully understand the terms of your loan.

  • Initial adjustment cap. This cap indicates how much the interest rate can increase the first time it adjusts after the fixed rate period expires. It is common for this cap to be 2%, which means that on the first rate change, the new rate cannot be more than 2 percentage points higher than the initial rate during the fixed rate period.
  • Subsequent adjustment ceiling. This clause indicates by how much the interest rate may increase in subsequent adjustment periods. This number is usually 2%, which means that the new rate cannot be more than 2 percentage points higher than the previous rate.
  • Lifetime Adjustment Ceiling. This term means by how much the interest rate can increase in total over the term of the loan. This ceiling is often 5%, which means that the rate can never be 5 percentage points higher than the initial rate. However, some lenders may have a higher limit.

An ARM can make sense for buyers planning to move before the initial rate period expires. However, as life goes by and it is impossible to predict future economic conditions, it is wise to consider the possibility that you may not be able to move or sell.

“I would also be concerned if you do an ARM with a low down payment,” said Stephen Rinaldi, president and founder of Rinaldi Group, a mortgage broker. “If the market corrects for some reason and home values ​​go down, you could be underwater on the house and unable to get out of the ARM.”

Rinaldi said ARMs tend to make the most sense for more expensive homes because the amount saved with the initial rate can reach thousands of dollars per year.

“The difference between 3.5% and 5% can be $400 a month,” Rinaldi said. “On an ARM 7/1, that could mean saving $5,000 a year or $35,000 in total, so I can see the logic in that.”

For a mortgage below about $200,000, the savings are less and may not be worth choosing an ARM over a fixed rate, he said.

“I don’t think it’s worth taking the risk to save about $100 a month,” Rinaldi said.

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