With Rates Expected to Fall, Is Now a Good Time for an Adjustable-Rate Mortgage?
April 1, 2024Navigating the complex landscape of home financing can be daunting. A few years ago, you could get a 30-year fixed rate mortgage between 2-3% and there weren’t many decisions to be made. It is a different story now.
The current mortgage landscape
As of March 21, 2024, national average mortgage rates according to Bloomberg.com stand at 7.15% for a 30-year fixed rate, 6.58% for a 15-year fixed rate, and 6.30% for a 5/1 Adjustable-Rate Mortgage (5/1 ARM). With these figures in mind, potential homeowners must understand the scenarios in which opting for an ARM could be more or less advantageous than a traditional fixed mortgage.
Let’s break down the numbers using a loan amount of $500,000 as an example to illustrate the principal and interest payments for each mortgage option. Insurance and property taxes are not included here for purposes of simplicity.
- 30-Year Fixed Rate at 7.15%: $3,377/ month for 30 years
- 15-Year Fixed Rate at 6.58%: $4,536/month for 15 years
- 5/1 ARM at 6.30%: $3,095/month for the first 5 years
Why consider an adjustable-rate mortgage?
Currently, 5/1 ARMs may offer an initial lower monthly payment compared to the fixed-rate mortgages, providing immediate savings. This feature makes ARMs particularly attractive to borrowers who expect rates to significantly decline in the future or may not stay in their home much longer than the initial fixed rate timeframe.
A practical example: from 5/1 arm to refinancing
Imagine you opt for a 5/1 ARM with the expectation that mortgage rates aren’t likely going higher. Here’s how refinancing in the future could play out.
- $3,095/month payments for the first 5 years
- Rates cooperate and the 30-year fixed mortgage rate drops by 2.0% to 5.15%. At this point you could either let the rate float if you think they’ll go lower, or you can lock it in.
- Let’s assume you lock it in by refinancing and $14,000 of refinancing costs are added to the loan balance which is now $480,700. Minimum monthly payments for the 30-year loan would be $2,625.
- However, instead of paying the minimum and extending the length of the combined loans to 35 years, you’d like to keep the original 30 years of payments and you decide to pay more than the monthly minimum. Monthly payments for the next 25 years would be $2,852 which saves $243/month compared to the initial 5-year ARM period.
- While the savings compared to the initial 30-year 7.15% fixed rate option would be even larger, you would also have had the same opportunity to refinance to a new loan with the 5.15% rate if you held the 30-year fixed loan.
- Therefore, the real savings in this ARM to refinance scenario comes from those first 5 years of the lower ARM rate. 60 payments that saved $282/month compared to the 30-year fixed loan provided a total interest savings of $16,920.
This scenario demonstrates a strategic financial move where an ARM provides initial savings and refinancing capitalizes on a future lower interest rate, further reducing monthly payments. It’s a compelling option for those confident in shifting economic conditions or have a short-term ownership horizon.
Risks to consider with an arm
Let’s look at some tradeoffs when electing an ARM.
- Uncertainty of interest rate movements – there is something to be said for having a known monthly mortgage payment. For those that don’t intend to sell the home within the next decade, get anxious with changing rate environments, or have monthly payments including taxes and insurance that exceed 20% of income, an ARM may not be a good fit. As an example, if rates on a 30-year mortgage rose by 2% from today to 9.15%, monthly payments could increase to $3,920 which is $543/month more than the initial fixed rated option.
- Cost of refinancing in the future – expenses include application fees, appraisal fees, title insurance, and other closing costs. According to bankrate.com, closing costs to refinance can be 2-5% of the loan amount.
Final thoughts
Choosing between an ARM and a fixed-rate mortgage should ultimately depend on personal financial situations and individual risk tolerance and less so on interest rate predictions. Consulting with a CERTIFIED FINANCIAL PLANNER® professional to navigate these decisions is highly recommended.