Adjustable-rate mortgages are growing in popularity, but they come with some big risks

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

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

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

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

Here’s how ARM loans work and what you need to pay attention to if you’re considering an adjustable-rate mortgage.

An adjustable-rate mortgage 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 rates shift.

A common type of adjustable-rate mortgage is the 5/1 ARM, where the introduction rate is set for the first five years and adjusts every year after that. ARMs come in all sorts of different flavors — the initial mortgage rate may last for one, seven or 10 years and the rate could change every six months, year, 3 years or 5 years depending on the loan’s structure.

If you’re considering an ARM loan it’s important to shop around and compare the rates, fees and types of adjustable-rate mortgages 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 lender fees.

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

• Qualifications: The low introductory interest rate of ARM loans doesn’t make them easier to qualify for. Lenders will want to make sure you can make your payments if the rates go up, and will set their standards accordingly.
• Rate caps: You’ll 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 specifics of these caps can make a big difference in how much you might have to pay.
• Refinancing: If you’re planning to refinance as soon as mortgage rates drop, you may be in for a world of disappointment if rates continue to rise or remain high. There may also be prepayment penalties if you pay off your loan early, so be sure to ask about those before applying.

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 expires.

If you plan on moving from your home before the ARM loan’s initial low-rate period expires, this type of mortgage can save you money compared with a fixed-rate mortgage (though you still have to account for possible prepayment penalties in your individual mortgage).

However, an ARM is subject to the whims of inflation. If inflation pushes interest rates higher, then your monthly payment can increase. Over the long haul, a 30-year fixed-rate mortgage provides a more predictable payment schedule and is also a great tool for combating rising housing costs. “In an inflationary environment, why are American homeowners [with a fixed-rate mortgage] in a better situation?” Mohtashami says. Your wages rise more during inflation, but a fixed long-term mortgage payment remains the same, which improves the homeowner’s cash flow.

ARM loans are more popular when mortgage rates increase and widen the difference between the average fixed-rate mortgage rate and the introductory teaser rate of an ARM loan.

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

Even though ARM loans tend to become more appealing when mortgage rates increase, these types of loans aren’t nearly as popular as they once were. Leading up to 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 that have since been effectively banned. There were option ARMs where you could choose between paying the full interest each month or only part of the interest and the rest would be added to the loan balance.

This made ARMs riskier over the long term, but the payments during the introductory period were significantly lower and investors who wanted to quickly sell the property for a profit weren’t concerned about paying down the loan balance.

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

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

However, fixed-rate mortgages have the advantage of providing stable payments over decades. The principal and interest rate 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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