September 15, 2022
Potential homebuyers are facing a double affordability whammy. It’s not news that prices remain quite high in many parts of the country, but the new wrinkle is that mortgages are now more expensive.
Ever since the financial crisis that began in 2008, it has been a no-brainer to opt for a fixed-rate mortgage, given their low rates. Locking in the same interest rate for 15 or 30 years was a great risk reduction move: Your payment in the last month of your mortgage would be exactly the same as the payment in the first month.
But fixed-rate mortgage rates have taken a steep climb. The average rate a year ago for a 30-year mortgage was below 3%. Today it is more than 5%.
That has sparked more interest in adjustable-rate mortgages (ARM) recently. The initial rate on an ARM will almost always be lower than the current rate for a fixed-rate mortgage. For instance, a 5/1 ARM has a fixed rate for the first five years, and then it can adjust (up or down) in subsequent years. The current start rate for a 5/1 ARM is around 4.4%, which can look mighty tempting compared to a 30-year fixed of 5.1% or so.
Please be very careful in making your mortgage choice. If you are seriously considering an ARM, here is what you need to ask yourself:
What’s the maximum increase at the first adjustment? Typically, it could be as much as two percentage points. I want you to use an online mortgage calculator to see what your monthly payment would be if you were hit with the maximum annual increase at the first adjustment. Can you handle that cost?
What is the maximum increase in the next year, and the year after? Following the initial period when an ARM’s interest rate is locked, the adjustments can be annual, not one-time. You need to understand your potential costs in each year once the mortgage enters its adjustable stage. (The initial period where an ARM has a fixed rate can vary. A 3/1 ARM starts adjusting after the third year. A 7/1 ARM after 7 years.) There is a lifetime cap, but it might be as much as six percentage points or so above the start rate.
What if I can’t refinance to get out of an ARM? There’s no guarantee you will be able to refinance into a fixed rate at some future date. As much as I hope your household is on the road to long-term financial freedom, refinancing requires having sufficient income and a solid credit score. There’s always a risk you may not qualify for a refi when you need it. Or as we saw in the Great Recession: There can be times when lenders make it extremely hard for anyone to qualify for a mortgage refi.
Please take all these questions to heart. If you want to move forward with an ARM, you should plan for the risk of your payments increasing over time. Even if those potential increases are affordable now, I think it’s smart to start setting aside extra emergency savings to cover the difference for at least the first two potential adjustments.
Could your ARM rate decrease? Absolutely! But building financial security is about preparing for potential challenges, not hoping for the best. None of us knows what the future holds for mortgage rates. When you choose an ARM, you must take steps now to prepare for the worst, not the best.
If you think you can’t afford a fixed-rate mortgage, I am going to ask you to stand in your truth. You likely can if you lower your price point for a home. Expand your search a little further from your dream neighborhood. Or consider the smaller home that fits your needs, with perhaps a bit less room, or bling. Reducing the amount you need to borrow is the best way to combat rising mortgage costs.