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Adjustable-rate mortgages, or ARMs, have a bit of a reputation.
After all, most subprime mortgages were ARMs during the 2008 housing market crash. Many Americans with low credit scores bought homes in the early 2000s with ARMs under easy lending conditions in a low-rate environment. But then interest rates rose, making monthly mortgage payments suddenly unaffordable and costing many their houses.
However, don't let the historical connotation of ARMs dissuade you from considering one. There are a couple of scenarios where an ARM could be quite useful, according to Redfin's Head of Economic Research Chen Zhao.
Unlike a fixed-rate mortgage, which has a consistent rate throughout, ARMs can fluctuate based on market conditions after an initial fixed-rate period. Typically, the initial rate for an ARM is lower than that of a fixed-rate mortgage. These initial fixed terms can last for five, seven, or ten years.
ARM underwriting is much stricter than it used to be, adding a guardrail against risky lending practices.
"You actually have to qualify where you're able to pay for a rate that has adjusted upward," said Zhao. "So there are fewer people who can qualify for ARMs."
As a result, there are fewer ARMs out there now than in the early 2000s. Pre-financial crisis, ARMs made up about a third of all mortgage originations, but now that number has generally hovered around the 10% mark, according to Zhao.
Zhao thinks many people overlook an attractive financing opportunity in the housing market by not considering an ARM.
"It is the case that probably more people actually should consider ARMs, because when rates are high, it does make financial sense for a lot of folks," said Zhao.
One group of buyers that should consider ARMs are short-term homeowners, according to Zhao.
"When you're thinking about ARM versus fixed, the first question you want to ask yourself is, 'how long do I want to be in this house for?'" Zhao said. "If it's less than 10 years, especially if it's less than five years, I think you should really consider an ARM."
For short-term homeowners, there's no reason to pay a slightly higher rate to lock in a 30-year fixed mortgage when you can get a cheaper initial rate through an ARM, in Zhao's opinion. They can then sell the house before the fixed-rate period ends, avoiding the risk of a potentially increasing mortgage rate.
Second, homebuyers should consider ARMs when rates are high and volatile, especially when rates are expected to decrease — as is the case now.
That's why homebuyers should also ask themselves whether rates are likely to be lower in the future than they are now, according to Zhao.
If the answer is yes, then you should go for an ARM. With the market anticipating a schedule of rate cuts starting in September, mortgage rates will likely settle at a lower baseline in the next few years. Zhao estimates that a neutral mortgage rate in the mid-5% range could be achieved by the end of 2025. Homeowners can then refinance their mortgages for cheaper in the future. Of course, there's no guarantee that rates fall in the years ahead.
An ARM does come with the risk of increased payments further down the road, but in some cases, it provides monthly savings with a low risk of higher payments down the line. For prospective homebuyers who answered "yes" to any of the two questions above, an ARM could be a good fit.
