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Understanding Adjustable-Rate Mortgages (ARMs)

Adjustable-rate mortgages, or ARMs, have started to recover from more than a decade of disinterest from both consumers and lenders. A type of mortgage that often offers lower introductory mortgage rates than conventional mortgage financing, ARMs are returning to the fold amid a sharp increase in home prices and fixed mortgage rates that began in early 2022.

What Is an Adjustable-Rate Mortgage, or ARM?

Adjustable-rate mortgages (ARMs) are a type of conventional mortgage in which borrowers pay a fixed rate for a number of years, and then a variable rate for the remaining mortgage payments thereafter. The most common type of ARM is known as a 5/1 ARM. With this arrangement, the homeowner pays a fixed interest rate during the first five years of a 30-year mortgage, and then a variable rate that can adjust once yearly for the remaining term of the mortgage.

How Does an Adjustable-Rate Mortgage Work?

A 5/1 ARM, for example, has a fixed-rate period of five years where the annual percentage rate is usually lower than what the same borrower might receive for a fixed-rate loan on the same property. But after those five years of fixed-rate payments, the variable-rate period begins. The new rate will be the sum of two values, a base interest rate based on a market index plus a margin—often 2.75 percentage points, but it can vary.

ARMs Get More Popular When Rates Are Higher

Today, for most current homeowners already with a fixed-rate mortgage, refinancing to an ARM would make little sense. The majority of homeowners with mortgages today are paying a fixed-rate APR of less than 4%, so monthly payments for both the fixed-rate portion as well as the variable rate would cost them more than their existing mortgage.

But for those shopping for a new home and mortgage, the decision is less obvious. Home prices are still elevated and interest rates sharply higher than they were throughout the 2010s. Average monthly payments for fixed-rate mortgages have increased by nearly 50% over the past year, when mortgage rates began to increase in early 2022. So even if consumers can find the right house to purchase, high monthly payments for a fixed-rate mortgage may be a deterrent.

Are ARMs a Good Decision?

It depends on a borrower’s situation, but generally homeowners could benefit from an ARM if they expect to move before the fixed-rate portion ends, or they expect their income to increase. That way, they can enjoy their lower monthly payments during the fixed-rate period without worrying too much about rates increasing.

Even if an ARM may be a preferable alternative to a fixed-rate mortgage for some consumers, you’ll still need to be approved, just as with a conventional fixed-rate mortgage. That means lenders will still want to see that you can manage your credit and monthly expenses when deciding whether to offer you any mortgage, fixed rate or adjustable.

ARMs Are Changing, but Payments Will Remain Nearly the Same

The variable-rate portions of ARMs are changing in 2023, after years of planning. Just as variable-rate credit cards track an index as part of a formula lenders use to assess interest on card balances, ARM rates also depend on a market rate as part of how the variable-rate portion of an ARM is calculated.

But instead of using the prime rate, which is what many variable-rate credit card lenders use, adjustable-rate mortgages will track something called the Secured Overnight Financing Rate (SOFR), which has replaced a similar metric. Many adjustable-rate mortgages have already switched to the SOFR to calculate monthly borrower payments.

Despite the change, the new SOFR is nearly identical to the variable rate it’s replacing, so current and future ARM borrowers will still pay roughly the same as they would have using the older calculation. The SOFR has historically remained nearly identical to a rate probably more familiar to business news watchers: the federal funds target rate, which is the main policy tool the Federal Reserve uses to manage inflation and borrowing costs.

Contact O1ne Mortgage for Your Mortgage Needs

At O1ne Mortgage, we understand that choosing the right mortgage can be a daunting task. Our team of experts is here to help you navigate the complexities of adjustable-rate mortgages and find the best solution for your financial situation. Whether you’re a first-time homebuyer or looking to refinance, we are committed to providing you with the best service and rates available.

Don’t hesitate to reach out to us at 213-732-3074 for any mortgage service needs. Let O1ne Mortgage help you get a foot in the door of your dream home with an adjustable-rate mortgage that suits your needs.

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