Is an ARM Mortgage a Good Idea in 2024?
News flash: mortgage rates are sky-high.
Unfortunately, this isn’t news at all. In fact, this is all homebuyers and homeowners have been hearing about since mid-2022 when 30-year fixed mortgage rates crested 5% for the first time in over a decade.
Now, even 5% seems like a mortgage shopper’s dream. Fixed rates are closer to 8%, especially for those with lower credit scores or small down payments.
When rates are this high, people have historically turned to adjustable-rate mortgages, or ARMs, to provide relief.
It seems to be happening again. According to the Mortgage Banker’s Association, nearly 10% of all mortgage applications were for ARMs during the first week of November 2023. That number was closer to 3% in March 2021, when fixed mortgage rates hit COVID-induced all-time lows.
With mortgage rates at two-decade highs, are ARMs a good idea for 2024?
The Argument For ARMs in 2024
While there’s no single right answer for everyone, here are some ARM advantages.
Qualify For More Home
Interest rates are the single biggest lever – even more important than home prices – when it comes to affordability.
Someone with a $100,000 salary might be able to afford a $370,000 home at 8%, but $425,000 at 6%*. That price change could mean the difference between a forever home and a temporary one.
You Might Refinance Soon Anyway
Mortgage rates are at 23-year highs according to Freddie Mac. Many believe mortgage rates have become unhinged from fundamentals, such as their relationship to the 10-year Treasury rate.
The Federal Reserve Bank of Richmond argues that mortgage rates currently reflect refinance risk more than borrower risk. After all, a mortgage becomes worthless to the end investor if the borrower refinances in a year. Some of the brightest minds in the world think rates will drop soon, igniting a refinance frenzy.
Getting an adjustable-rate mortgage at the top of a mortgage rate cycle could be a savvy move because you might refinance soon any, or for other reasons explained next.
Your Payment Could Drop, No-Refinance Required
Everyone knows ARM rates can rise, but few realize they can also fall.
For instance, you get a 3-year ARM at 6.5%. It’s fixed for three years, then adjusts to market rates. In three years, mortgage rates drop to 5%. Your rate and payment will start falling automatically.
ARMs typically follow an index, or a measure of current interest rates. As the index falls, so does your mortgage rate.
This could save thousands of dollars in refinance closing costs and weeks of gathering personal documentation.
ARMs Come With Borrower Protections
ARMs come with borrower protections called “caps.” For example, a 5-year ARM might come with 2/2/5 caps. This means:
The interest rate can’t rise more than 2% at the first adjustment
It can’t rise more than 2% at each subsequent adjustment
It can never rise more than 5% above the start rate
For example, an ARM with a 6% start rate could rise to 8% at the first adjustment, 10% at the second adjustment, but could never rise above 11%. Adjustment periods are typically six or 12 months.
In real terms, a $400,000 mortgage at 6% would have a principal and interest payment of about $2,400. It could rise to a maximum of about $2,900 at the first adjustment after the fixed term expires in five years. The payment could never rise above $3,800, not including taxes and insurance.
This structure gives you five years before any payment increase, at which time the maximum possible increase would be relatively modest.
Keep in mind that these are worse-case scenarios, not how much the rate will necessarily rise.
It’s also important to check an ARM’s caps in your initial loan disclosures. Some come with 5/2/5 or 6/2/6 caps, which means they can "top out" at the ARM's maximum rates at the first adjustment.
ARM Drawbacks for 2024
ARMs have serious advantages for some consumers, but here are the risks.
Rates Could Continue Upward
There’s no rulebook saying mortgage rates have to start dropping. Getting an ARM might be a temporary protection only. Your payment could rise after the fixed period three to five years from now. All it would take is for mortgage rates to stay where they are for your payment to rise in a few years.
You Might Not Qualify for a Refinance in the Future
The age-old strategy for ARMs is to refinance out of them when the time comes.
Not only is this costly, but it’s also not guaranteed. You might lose your job or experience a credit score hit. This could make a refinance untenable due to cost or disqualification.
You Might Not be Able to Sell
If your payment rises too much in the future, you could be forced to sell the home. In 2024, selling a home might be easy. But in 2029 or 2030, it may not be.
A forced sale in a buyer’s market is a losing proposition. In 2009 through 2011, many people could not sell their homes at any price.
ARMs Aren’t Always Cheaper
As mentioned, today’s mortgage market is not following historical norms. You might be quoted an ARM rate that’s higher than current fixed rates. Or your lender may not offer ARMs at all.
According to Mortgage News Daily, the average 5-year ARM rate was 7.09% at the time of this writing, compared to a 30-year fixed average of 7.45%, hardly a discount.
That being said, some lenders specialize in these programs and offer rates about 1% to 1.5% below market fixed rates. Shop around and see how much you can save.
When ARMs are Usually a Good Idea
In certain circumstances, a fixed-rate loan doesn’t make sense.
Windfall: If you plan to pay off the mortgage with an inheritance or other windfall soon, it makes little sense to get a high fixed-rate loan.
Plan to move: If you plan to sell soon, an ARM could be beneficial. However, consider the cost. It could make economic sense to rent for 2-5 years instead of buying and selling. If you're considering refinancing into an ARM, make sure your closing costs don't outweigh interest savings.
Plan to refinance: Some loans are temporary in nature; they are meant to secure the home purchase only. Some examples are construction loans and bank statement loans. You will refinance once the home is complete, you have steady employment, or your credit score rises.
Bottom Line: What Mortgage Shoppers Should Know About ARMs in 2024
To decide for or against an ARM, it’s important first to know that ARMs are cheaper because they are more risky. With a fixed rate, the lender takes on all the risk that rates will rise in the future. With an ARM, the lender shares that risk with you and rewards you with a lower starting rate.
Those who love risk in exchange for reward might do well with an ARM. Risk-averse borrowers should avoid them, if for nothing else, to sleep better at night.
Always discuss your choice to get an ARM with your financial planner, mortgage loan officer, and other financial professionals in your life
*Assumes a conventional loan, 36/45 ratios, low debt, good credit.
