Are ARMs (adjustable-rate mortgages) worth the risk?
First, let’s take a look at how ARMs work. Then, we’ll take a look at the numbers.
What is an ARM (adjustable-rate mortgage)?
I’ll go over what I consider the important things to know about ARMs. If you want all the details, here’s a great resource.
With an adjustable-rate mortgage, the interest rate can change over the life of the loan. With a fixed-rate mortgage, the interest rate will stay the same.
ARMs have an initial rate. The initial rate is lower than what you can get for a 30-yr fixed rate.
For example, you may see a 7/6 ARM or a 10/6 ARM. Your initial rate is fixed for the first 7 or 10 years, and it can change every 6 months after that. The second number tells you how often the rate will change after the initial period.
Keep in mind, ARMs are amortized over 30 years. If you pay minimum payments, it will take 30 years to pay off the loan.
Let’s take a look at a quick example from one of my lenders (as of 1/11/23):
Conventional Conforming 30-Year Fixed* – 5.875% (no points)
7/6 ARM* – 5.125% (0.25 points)
10/6 ARM* – 5.125% (0.25 points)
*the rates posted here are for educational purposes only
As you can see, there is a 0.75% or 75 basis point difference between the 30-year fixed and the ARMs. The points are discount points, meaning you will have to pay 0.25% of the amount you are borrowing to get that rate. For example, if you are borrowing $400,000, you’d pay $1,000 to pay the 0.25 discount points.
If you are borrowing $400,000, a 0.75% difference in rate would save you almost $3,000 in the first year. The amount you save slowly decreases as you slowly pay down your principal (since your loan is smaller).
One thing to note here is that the 7/6 ARM and 10/6 ARM have the exact same rate in the example above. Usually, you’d expect to see the 7/6 ARM with a lower rate than the 10/6 ARM as you would pay a premium for a longer fixed period at a lower rate.
What are some of the risks of an ARM?
The main risk is that your interest rate could go up after the initial fixed period. If the rate goes up, your monthly payment will go up. If your income doesn’t increase over time or you take on more debt, you could potentially lose your home or have to sell.
How much can the rate go up with an ARM?
For this, I asked Sylvia Bae of First Heritage Mortgage for some guidance. ARMs will come with caps, usually expressed as 3 numbers. For example, you may see an ARM with 5/2/5 caps.
The first cap is the initial adjustment cap, which tells you how much the first adjustment can be after the fixed period.
The second cap is the periodic (or subsequent) adjustment cap, which tells you how much the rate can change every year or 6 months, for example.
The third cap is the lifetime cap, which tells you how much the rate can adjust over the life of the loan.
For this example, if you started with a 5% rate, your rate could never adjust over 10% in the example above.
Another loan officer I’ve worked with, Anna Tapparo of First Savings, has a 5/5 ARM product with 2/2/5 caps. For these loans, the rate adjusts every 5 years after the initial period. Since the initial and periodic caps are both 2, your rate can only increase by up to 2% in the first 10 years.
Are LOs (loan officers) and realtors recommending ARMs?
Many LOs are recommending ARMs right now as buyers can always refinance if the rates go down.
As a real estate agent, I like to educate my buyers on the pros and cons of ARMs and the risks. When the interest rates were in the 2s and 3s, I would always recommend a fixed rate. With rates around 6% now and a 75 basis point difference/gap between fixed and adjustable rates, the conversation becomes a little more interesting. If I were buying right now, I personally would probably use a 7 or 10 year ARM. Everyone’s situation is different, so educate yourself on the pros and cons. Then, make a decision.
I’ll go into the numbers below.
Quick note: Most people plan to stay in their home for a very long time, but realistically, people move a lot more often than they expect. This is from an article at the Census Bureau:
Using 2007 ACS data, it is estimated that a person in the United States can expect to move 11.7 times in their lifetime based upon the current age structure and average rates and allowing for no more than one move per single year. At age 18, a person can expect to move another 9.1 times in their remaining lifetime, but by age 45, the expected number of moves is only 2.7.
According to Nilesh Makhija of Buckingham Mortgage, getting an adjustable-rate mortgage makes the most sense in situations where there’s a big gap between fixed and variable mortgage rates and an expectation that at least one of the following situations will occur during your fixed term:
- You’ll sell the property
- Interest rates will decline, giving you the opportunity to refinance into a fixed mortgage
- Your rate caps are manageable, and you can still afford the home during the variable period, assuming a worst-case scenario
Now, let’s look at some numbers.
For this example, I’m going to use the rates quoted in the example above (from 1/11/23) and disregard discount points. I’ll also assume a loan of $400,000 and a purchase price of $500,000 with a 20% down payment. Purchase price isn’t really too relevant for this analysis.
Conventional Conforming 30-Year Fixed – 5.875%
7/6 ARM – 5.125%
10/6 ARM – 5.125%
Purchase price: $500,000
Loan: $400,000
$400,000 loan with a 30-year fixed at 5.875%
The monthly payment on this loan would be $2366.15.
$400,000 loan with a 7/6 ARM at 5.125%
The monthly payment for the first 7 years would be $2177.95.
$400,000 loan with a 10/6 ARM at 5.125%
The monthly payment for the first 10 years would be $2177.95.
The difference in monthly payment is $188.20.
Over 7 years, that’s $15,808.80.
Over 10 years, that’s $22,584.
Here’s an annual amortization schedule for the first 10 years at 5.875%:
| Beginning Balance | Interest | Principal | Ending Balance | |
| 1 | $400,000.00 | $23,366.05 | $5,027.75 | $394,972.24 |
| 2 | $394,972.24 | $23,062.59 | $5,331.21 | $389,641.01 |
| 3 | $389,641.01 | $22,740.80 | $5,653.00 | $383,988.00 |
| 4 | $383,988.00 | $22,399.60 | $5,994.20 | $377,993.78 |
| 5 | $377,993.78 | $22,037.78 | $6,356.02 | $371,637.76 |
| 6 | $371,637.76 | $21,654.14 | $6,739.66 | $364,898.11 |
| 7 | $364,898.11 | $21,247.35 | $7,146.45 | $357,751.66 |
| 8 | $357,751.66 | $20,816.02 | $7,577.78 | $350,173.87 |
| 9 | $350,173.87 | $20,358.64 | $8,035.16 | $342,138.70 |
| 10 | $342,138.70 | $19,873.64 | $8,520.16 | $333,618.54 |
Here’s an annual amortization schedule for a loan at 5.125%.
| Beginning Balance | Interest | Principal | Ending Balance | |
| 1 | $400,000.00 | $20,365.72 | $5,769.68 | $394,230.35 |
| 2 | $394,230.35 | $20,062.98 | $6,072.42 | $388,157.96 |
| 3 | $388,157.96 | $19,744.36 | $6,391.04 | $381,766.94 |
| 4 | $381,766.94 | $19,409.02 | $6,726.38 | $375,040.59 |
| 5 | $375,040.59 | $19,056.08 | $7,079.32 | $367,961.29 |
| 6 | $367,961.29 | $18,684.61 | $7,450.79 | $360,510.53 |
| 7 | $360,510.53 | $18,293.66 | $7,841.74 | $352,668.82 |
| 8 | $352,668.82 | $17,882.20 | $8,253.20 | $344,415.65 |
| 9 | $344,415.65 | $17,449.14 | $8,686.26 | $335,729.42 |
| 10 | $335,729.42 | $16,993.37 | $9,142.03 | $326,587.42 |
Let’s take a look at the ending balance after 7 and 10 years:
After 7 years, your ending balance with the ARM would be $352,667.82 vs $357,751.66 with the fixed rate.
That’s only a difference of $5,083.84 in principal balance. But remember, you also paid $15,808.80 less in payments.
After 10 years, your ending balance with the ARM would be $326,587.42 vs $333,618.54 with the fixed rate.
That’s only a difference of $7,031.12 in principal balance. But remember, you also paid $22,584 less in payments.
But wait! Let’s look at one more situation.
Remember the monthly payments were $2,366.15 for the fixed vs. $2,177.95, which is a difference of $188.20.
Suppose that, instead of spending the extra $188.20, you made the same $2,366.15 payment on the ARM that you would have made if you took the fixed rate. Let’s take a look at the ending balance after 7 and 10 years.
Note: the numbers below may be slightly off as the amortization calculator I used for extra payments didn’t go to the thousandths digit.
| Date | Principal | Interest | Remaining balance |
|---|---|---|---|
| 2023 | $7,394.98 | $18,616.92 | $392,605.02 |
| 2024 | $15,867.19 | $38,521.31 | $384,132.81 |
| 2025 | $24,783.50 | $57,981.61 | $375,216.50 |
| 2026 | $34,167.20 | $76,974.52 | $365,832.80 |
| 2027 | $44,042.78 | $95,475.55 | $355,957.22 |
| 2028 | $54,436.03 | $113,458.91 | $345,563.97 |
| 2029 | $65,374.07 | $130,897.48 | $334,625.93 |
| 2030 | $76,885.48 | $147,762.68 | $323,114.52 |
| 2031 | $89,000.30 | $164,024.47 | $310,999.70 |
| 2032 | $101,750.16 | $179,651.22 | $298,249.84 |
Whoa! Look at those numbers now!
If you paid the $188.20 you saved with the lower rate into your mortgage instead:
After 7 years, your ending balance with the ARM would be $334,625.93 vs $357,751.66 with the fixed rate.
That’s a difference of $23,125.73 in principal balance.
After 10 years, your ending balance with the ARM would be $298,249.84 vs $333,618.54 with the fixed rate.
That’s a difference of $35,368.70 in principal balance.
So, after 7 or 10 years, you’d be $23k or $35k ahead, and you’d always have the option to refinance to a fixed rate during this period. These numbers are for a 75 basis point difference assuming a $400k loan.
Other notes
For qualification purposes, you may need to financially qualify for a higher rate than the initial rate if you are doing a 5-yr ARM. Here is the qualification info:
- 5/6 ARM, qualify at the fully indexed rate or 2-5% above the start rate depending on the program
- 7/6, 10/6 and 15/6 ARM, qualify at the start rate
Also, note that there are no more programs that allow /1 (one year) adjustable rate since London Interbank Offered Rate (LIBOR) that allowed one year adjustable period is not used as the mortgage index any more. There are only /6 (every six months) rate change programs since the Secured Overnight Funds Rate (SOFR) is the index tied to all ARMs in the US now.
Here is another sample scenario provided to me by a lender:
Scenario:
- 7/6 ARM rate at the time of home settlement: 5.125% with 5/1/5 caps
- SOFR index: 4.31% (this is the index today but could be different at the time of rate adjustment)
- Margin: 3%
Under the above scenario, the bank will fully index the rate (4.31 index + 3 Margin) which is 7.31%. Since initial cap is at 5% above the start rate (10.125%), the initial adjusted rate will be 7.31%. For the subsequent change, the bank will fully index the rate using the index rate at that time. If the index has increased to 5, then the fully indexed rate would be 8% (5+3). Since each individual periodic rate is capped at 1%, the resulting rate to the homeowner would be adjusted to 8% even though the last adjusted rate of 7.31% + 1 cap is 8.31%. However, if the fully indexed rate became 8.5% due to an increase in index at the time of adjustment, the homeowner rate would be 8.31%. The fully indexed rate will be the effective rate staying within the allowed caps.
Questions?
Even though this is a long post, there’s a lot about ARMs that I didn’t cover. Please consult your loan officer for more details.
If you are looking for a loan officer in the Northern Virginia area, I have some loan officers listed here.
If you are looking to buy or sell in Northern Virginia, I am a licensed realtor at The K Group of Samson Properties.
Feel free to reach out to me at realtordannylee@gmail.com or (401) 261-0044.