With Rising Interest Rates, Do Adjustable Rate Mortgages Make Sense?

Don't let any fast-talking mortgage broker tell you otherwise: Signing up for an adjustable rate mortgage is a throw of the dice on the future of the real estate market.

But it's a gamble that an increasing number of home buyers are taking. As home prices soar across the country and interest rates rise, adjustable rate mortgages, with their initially lower rates, are grabbing a larger share of the mortgage market.

Whether ARMs, as these typically 3, 5 or 7-year mortgages are known, are worth the risk is another matter. While they may be the right choice for some buyers, for others, rushing into an ARM could set them up for an unpleasant financial shock down the line, experts say.

Buyers who purchase a home with an ARM benefit from a lower, fixed rate for the first 3, 5 or 7 years, depending on the loan's length. (In fact, it is often lower than what you could get on a traditional, fixed 30-year mortgage.) But once that initial period ends, the rate on the mortgage can increase, sometimes substantially if interest rates have risen during the same period.

"This is highly dependent on how long the client is planning on living in the home," says Matthew Gaffey, senior wealth manager at Corbett Road Wealth Management in Potomac Falls, Va. "If they are fairly sure their stay in their home will be relatively short-lived, the resulting rise in their mortgage payment from a rate adjustment may be fairly irrelevant."

Adjustable rate mortgages accounted for 6.6% of all mortgages issued in the U.S. in April, up more than 50% since the end of 2016, according to Ellie Mae.

So why are ARMs gaining popularity? Certainly rates are a big reason, though the cost of taking out an adjustable rate mortgage is also on the rise as well.

Rates on fixed 30-year mortgages are hovering around 4.5%, up from a low of 3.43% back in August, 2016. While the cost of a 5-year ARM recently increased 13 basis points, at 4.43% it is still cheaper than a 30-year loan.

In March, the gap was significantly higher: 4.71% for a 30-year fixed compared to a 3.98 rate for a five-year ARM.

Those lower interest costs, in turn, are proving attractive to home buyers, especially first-timers, confronted with rising prices, especially in hot markets like Seattle, Boston, New York and San Francisco.

New construction that's not keeping up with demand and a dearth of available listings has forced buyers in many markets to stretch their finances in order to buy, with ARMs a way to make their money go farther.

So when does it make sense to do an ARM?

The main case for buying a house with an ARM is if you don't plan to be living in it for years to come. Rather, you expect you will be selling in the next five to seven years because you want to move up to a larger home or you will be moving to a new area.

In this case, the problem that comes with an ARM - the loss of a fixed rate and suddenly rising mortgage costs - takes care of itself. You will be rolling into a new house and a new mortgage and at that point can plan on a 30-year fixed, or, for that matter a 15-or-20-year fixed rate loan, depending on how much equity you were able to reap from the sale of your previous home.

"You should try to match the fixed portion of your mortgage to the time you intend to live in the property," says Eric Dostal, a vice president and certified financial planner at Sontag Advisory in New York. "If this is a starter home a 7/1 ARM can make a lot of sense. If you are purchasing a forever home a 30 or 15-year fixed makes more sense. It all depends on what the plan is."

But if you are planning to stay in your house for the long-term - if this is your "forever" home - the risk you could get stuck with a bad deal when the ARM expires in five or seven years is too high, financial advisors say.

In fact, while mortgage brokers and bankers like to talk up ARMs, many financial advisors are not exactly thrilled with the idea.

David Demming, a certified financial planner and president and founder of Demming Financial Services in Aurora, Ohio, has had a mortgage license for 25 years. But he avoids ARMs, preferring instead to put clients in 10-15 year, fixed-rate mortgages.

"Adjustable rate mortgages could best be referred to as "Bait and switch" because they start low and generally go higher," Demming says. "Only a fool would take out that loan today, the exception would be a short-term owner with say a five-year rate lock."

For his part, Michael Ciccone, a certified financial planner and associate vice president at Tradition Advisers in Summit, N.J., sees historical trends working against the return anytime soon of the super-low interest rates of recent years.

"Not only are interest rates primed to rise, but they are also currently very low compared to historical averages," Ciccone says. "It would be unlikely to see rates at or below current levels again in the next 30 years."

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