Understanding the home buying process before you start shopping for a home can make it easier.
Mortgage rates are still rather elevated relative to recent years, and it has made homeownership far less affordable for many Americans.
One way to potentially save money when buying a home is to use an adjustable-rate mortgage, or ARM. An adjustable-rate mortgage is typically a 30-year loan that has a fixed interest rate for a certain length of time, usually five or seven years. After this time, the mortgage’s interest rate will periodically adjust higher or lower depending on prevailing interest rates at the time.
To be sure, ARMs aren’t right for everyone. But they generally have lower interest rates than comparable 30-year fixed-rate mortgage loans. So, here’s a look at just how much of a difference an ARM can make in your monthly payments and your long-term cost of ownership.
According to the Mortgage Bankers Association (MBA), the average interest rate on a 30-year fixed-rate mortgage in the last week of April 2023 was 6.55% with 0.63 points. (Note: Mortgage points are an upfront cost associated with a mortgage and one point equals 1% of the initial loan amount.)
On the other hand, the average 5/1 adjustable-rate mortgage had a 5.47% rate during the same week, with 1.18 points. When you sign on for a 5/1 ARM, it means your initial rate is fixed for the first five years, and then adjusts according to a certain benchmark index every year thereafter.
Let’s say you want to buy a $500,000 home with 20% down, so you’ll need a $400,000 mortgage. You’re trying to decide if a 30-year fixed-rate loan or a 5/1 ARM is the best choice for you.
As we’ll discuss later, there are other things to consider besides the cost difference, but here’s how the numbers work out over the first five years of ownership.
If you obtain a 30-year fixed-rate mortgage with the average 6.55% interest rate, your monthly principal and interest (P+I) payments will be $2,541. With a 5/1 ARM that comes with a 5.47% interest rate, your monthly P+I would be $2,264.
Now, notice that the typical ARM has higher points, and this would mean an additional upfront cost of $2,200. However, the difference in mortgage payments would mean saving $16,620 over the first five years of ownership, so even with the higher points, your out-of-pocket costs would be more than $14,000 less over five years with an ARM.
As you can see, an adjustable-rate mortgage can result in significant cost savings over the first few years you own a home. And if rates fall between now and when your initial rate period expires, it’s even possible your rate could go lower once it adjusts.
However, it’s not a wise financial move to plan on that. The smart move is to assume that your ARM’s interest rate will go up after your first adjustment and plan accordingly. Therefore, an ARM is usually best for homeowners who plan to sell their home before the initial rate period ends or those who are confident they’ll be able to refinance their loan with favorable terms before it does — and there is absolutely no guarantee you’ll be able to.
The bottom line is that while an adjustable-rate mortgage can be a good tool to increase your home’s affordability, it isn’t without its drawbacks.
This article was written by Matthew Frankel, CFP® from The Motley Fool and was legally licensed through the Industry Dive Content Marketplace. Please direct all licensing questions to email@example.com.