Housing prices are finally starting to go down, but thanks to interest rate hikes, monthly mortgage payments are more out of reach than ever before. With all of this financial uncertainty, you may be considering an adjustable-rate mortgage, which are starting to increase in popularity once again. If that term sounds familiar, that’s because it’s the same type of loan that played an instrumental role in the 2008 housing crash—and it’s one you should still avoid today.
What is an adjustable-rate mortgage?
An adjustable-rate mortgage (or ARM) starts with a locked-in interest rate that is lower than a conventional fixed-rate mortgage for the first (typically) 5-7 years of the loan. However, the interest rate can increase (or decrease) after that initial period expires based on what the rate is at the time. So while it has the advantage of starting with a lower monthly payment than a fixed-rate mortgage, it’s a risky option because payments for an adjustable-rate mortgage can change over time—sometimes by a lot. Meanwhile, a fixed-rate mortgage will remain the same for the entirety of the loan.
It’s important to also know that your ARM payment can still increase even if interest rates drop. That’s because adjustable-rate mortgages have a limit on how much interest rates can go up in a year. However, it also may have the ability to carry over that extra hike over to a future rate adjustment. So while others are seeing rates go down, yours could go up.
Is an ARM ever a good idea?
An adjustable-rate mortgage is a gamble that either interest rates will drop in the future, making it possible to refinance at a lower monthly payment, or that their personal income will rise in the future, making it possible to pay a higher monthly rate if or when the rate on the loan rises. And even if interest rates drop in the future, the buyer may not be able to refinance because of a low credit score, or because their house value has dropped below what they still owe on it. (Housing prices can fall to the point that you owe more on it than it is worth—that’s what happened in 2008, when prices dropped by about 20%.)
It might make sense for those who know they plan to sell the home before the end of the fixed-rate period: That means they’d take advantage of the lower rate for a short time and get out before the rate potentially increases. Of course, it’s important to keep in mind that unforeseen circumstances may prevent you from selling when you want to, so it’s still a risk.