Building off of my colleague’s article from earlier this month, which you can view here, over the last 6 months, the average rate on a 30-yr fixed rate mortgage has jumped from around 3.25%- 3.5% to 5.75-6.00%, levels not seen since November of 2008. To put those numbers in perspective, assume you purchase a $350,000 home with 20% down, meaning you have a $280,000 mortgage. If you would have locked in a rate at 3.25%, your monthly payment would have been $1,218. Currently, assuming a 5.75% interest rate, that same mortgage would cost you $1,634. Annualize that, and your mortgage alone is costing you almost $5,000 more a year! Not only are potential homebuyers dealing with a dramatic increase in mortgage rates, but the price of just about everything has increased significantly from gas, food and home prices themselves. The median listing price for a home in Knoxville, TN has increased 29% YoY, due to major supply/demand imbalances that will take time to work itself out.
So, besides being patient (which your personal circumstances may or may not allow) what other options do you have? Now may be a good time to look at the pros and cons of an Adjustable-Rate Mortgage (ARM) and see if it makes sense for you and your family.
An adjustable-rate mortgage (ARM) is a home loan with an interest rate that adjusts over time based on the market. ARMs typically start with a lower interest rate than fixed-rate mortgages for a set period of time (i.e. 3, 5, 7 years etc.) called the teaser rate. Once the fixed period ends, your interest rate adjusts at some pre-determined frequency based on a pre-determined index. Given the complexity of ARMs, it is important to understand the terminology/numbers that you will come across if deciding to go this route. You will see numbers such as 5/1, 5/6, 3/1 etc. The first number is how long the teaser (fixed-rate) period will last. The second number is how often rates are adjusted, so a 5/1 has a fixed rate for 5 years that adjust once per year after the initial fixed rate period ends. A 5/6 ARM has a fixed rate for 5 years that adjusts every 6 months after the fixed period ends. You will also see ARMs that may be advertised as a 5/1 with 2/2/5 caps. The first number related to the cap is how much the interest rate can adjust with the first adjustment, in this case 2%. The second number is the cap on subsequent adjustments, which means each rate adjustment after the initial one can’t increase by more than 2%. The last number is the lifetime limit on increases, so in this case, during the life of the loan, your interest rate can’t increase more than 5%.
Again, ARMs are complex, and it takes due diligence on the buyers end to make sure you know what you are getting. Given the complexity, you may ask yourself in what situation would an ARM be prudent for me and my family? Well, there are many things to consider but one, if not the most important, is the current interest rate environment. With the dramatic increase in interest rates over the last 6 months (and with the belief by many that rates won’t stay elevated for an extended period of time), demand for adjustable-rate mortgages have surged to 14-year highs.
ARM rates vary depending on the exact terms of your mortgage but can be around 0.5%-1.0%+ lower than a comparable fixed-rate mortgage. Additionally, the time-frame you plan to live in the home is also another key consideration. ARMs are generally more favorable for short-term homeowners as you can lock in the teaser rate (which would be lower than rates for a comparable fixed-rate mortgage) and then not live in the property long enough to see rates adjust. Another factor to consider is possible income increases in the short-to-intermediate term. If you expect your income to increase substantially over the next several years, then your cash flow should be more than sufficient to deal with a potential increase in rates when your adjustment period begins.
I can’t stress enough that ARMs need to be evaluated on a case-by-case basis. There are many factors to consider, and what I have listed above are just a few. My job as a financial professional is to offer peace of mind to our clients. Knowing that you have a team to rely on to help analyze and make tough decisions (like appropriate home financing strategies) can give you that peace of mind. Do you have someone you can lean on?
