Adjustable rate mortgages are becoming more popular with rising interest rates

Adjustable rate mortgages (ARMs) tend to become more popular as interest rates rise and borrowers look for ways to save on interest.

As mortgage rates hit historic lows in 2021, ARMs accounted for less than 2% of mortgage applications. As interest rates rose in 2022, the share of ARM loan applications peaked at nearly 13%, according to the Mortgage Bankers Association Weekly Applications Survey.

While an adjustable-rate mortgage may be cheaper in the short term, the savings may not last if interest rates continue to rise, making ARMs riskier than fixed-rate mortgages. Also, the rules for ARM loans have changed over time, making them less appealing. You can’t qualify for an ARM like you used to, and the savings may not be as beneficial as they once were, says Logan Mohtashami, senior analyst at HousingWire.

That said, ARM loans can be useful in a high-interest environment when the borrower knows they won’t be staying in their home for decades.

Here’s how ARM loans work and what to look for if you’re considering an adjustable rate loan.

An adjustable-rate loan comes with a low introductory interest rate for a set period, and after the teaser rate expires, the loan’s interest rate changes as mortgage interest rates change.

A common type of adjustable rate loan is the 5/1 ARM, where the introductory rate is fixed for the first five years and is adjusted every year thereafter. ARMs come in all sorts of different flavors — the original mortgage rate can last for one, seven or 10 years and the rate can change every six months, every year, 3 years or 5 years depending on the structure of the loan.

If you’re considering an ARM loan, it’s important to shop around and compare the rates, fees and types of adjustable rate loans offered by different lenders. Better and Ally Bank both offer a variety of ARM loans and fixed-rate mortgages, but the best part is that neither lender charges loan fees.

When you apply for an adjustable-rate loan, several things are important to be aware of.

• Qualifications: The low initial interest rate on ARM loans doesn’t make them any easier to qualify for. Lenders want to make sure you can make your payments if rates rise and will set their standards accordingly.
• Price limits: You will also want to ask the lender about the rate adjustment caps. ARMs have limits on how much the interest rate can increase at one time and over the life of the loan. As you might imagine, the special characteristics of these ceilings can make a big difference in how much you might have to pay.
• Refinancing: If you plan to refinance as soon as mortgage rates drop, you could be in for a world of disappointment if rates continue to rise or remain high. There may also be prepayment penalties if you repay your loan early, so be sure to ask about them before you apply.

The biggest downside to an ARM is that your monthly payment can increase, and that’s a risk you should be prepared for when the introductory period ends.

If you plan to move out of your home before the ARM loan’s initial low-rate period ends, this type of mortgage can save you money compared to a fixed-rate mortgage (although you still need to factor in possible prepayment penalties in your individual mortgage).

However, an ARM is subject to the vagaries of inflation. If inflation pushes up the interest rate, then your monthly payment may increase. In the longer term, a 30-year fixed rate mortgage provides a more predictable payment schedule and is also a good tool to combat rising housing costs. “In an inflationary environment, why are American homeowners (with a fixed-rate mortgage) in a better situation?” says Mohtashami. Your wages rise more below inflation, but a fixed long-term mortgage payment stays the same, improving the homeowner’s cash flow.

ARMs are more popular when mortgage rates rise and widen the gap between the average fixed rate mortgage rate and the initial teaser rate for an ARM loan.

In January 2021, when mortgage rates hit record lows, the average 5/1 ARM teaser rate was actually higher than the average 30-year fixed mortgage rate, according to the Freddie Mac Primary Mortgage Market Survey. But as mortgage rates rose at a historic pace in 2022, the average 5/1 ARM intro rate was 1%+ lower than the average 30-year fixed mortgage rate for most of the year.

Although ARMs tend to become more appealing as mortgage rates rise, these types of loans are not nearly as popular as they once were. Before the Great Recession, ARM loans accounted for over a third of all mortgage applications at their peak, according to the Mortgage Bankers Association Weekly Applications Survey.

These loans had repayment terms which have since effectively been banned. There was the option of ARMs where you could choose to pay the full interest each month or just a portion of the interest and the rest would be added to the loan balance.

This made ARMs riskier in the long term, but the payments during the introductory period were significantly lower, and investors who wanted to quickly sell the property at a profit were not worried about paying down the loan balance.

At the same time, the lending standards for ARM loans were far less stringent, “you just needed a pulse to qualify for them,” says Mohtashami. These factors contributed to the housing crash of 2008. Since then, lending guidelines have tightened and the same type of ARM loan is no longer available. “A lot of ARM products right now aren’t that much different than the 30-year staples,” Mohtashami says.

ARM loans become more popular as interest rates rise because they can be cheaper in the short term. If a homeowner knows they won’t be living in the home long term, the savings may be worth it.

However, fixed-rate mortgages have the advantage of providing stable payments over decades. Principal and interest payments for a 30-year fixed-rate mortgage never change. So as your income increases over time, your housing costs will take up a smaller percentage of your income.

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