Many First-Time Homebuyers Could Use a Hand: Will an ARM Suffice?

With mortgage rates, home prices, and rents all rising rapidly, many first-time homebuyers are stuck between a rock and hard place when it comes to housing.

Renting can be cheaper in the short term (depending on the area), but at the end of the day renters are building their landlord’s equity instead of their own.

So what can homebuyers do with affordability eroding by the day? One strategy to reduce upfront costs and potentially get into homeownership sooner is to use a 5/1 adjustable-rate mortgage (ARM) instead of the traditional 30-year fixed rate mortgage.

What is an adjustable rate mortgage?

An adjustable rate mortgage is a loan that has a low introductory rate that later adjusts with the market.

There are a few variations of this loan type, but the most common is the 5/1 ARM. In this loan, the initial mortgage rate is fixed for five years and then adjusts to the market rate once per year for the remainder of the loan term.

The loan length is typically 30 years, so it adjusts for the last 25 years, if you keep the loan that long. It does not come with a balloon payment where you owe the remaining loan balance at the end of five years.

In a fixed-rate mortgage – as the name suggests – the rate is locked for the life of the loan.

Why would homebuyers use an ARM?

There are several reasons someone would choose an ARM over a FRM, but it all boils down to saving money – in the short-term, long-term, or both.

The initial rate on an adjustable rate mortgage is typically lower than a 30-year fixed rate. That’s especially true now with mortgage rates surging.

In March, the 1.17 percentage point gap between the 5/1 ARM and 30-year FRM is the widest since September 2015, according to the Freddie Mac Primary Mortgage Market Survey. The difference in mortgage rate amounts to a monthly mortgage payment that’s nearly $250 cheaper on a $400,000 home with 10% down.

For first-time homebuyers, that may be the difference between busting their monthly budget and and having a small cushion.In other words, some homebuyers simply can’t afford a 30-year fixed-rate mortgage, and an ARM provides a backdoor to homeownership and long-term wealth creation.

But that’s just one reason to consider a 5/1 ARM.

Other reasons to choose and adjustable-rate mortgage include:

1. You only plan to live in the home for 5 years or less, in which case you won’t have to worry about the rate adjusting higher
2. You think your income will rise and you will be able to handle a potentially higher payment later on
3. You plan to refinance within 5 years
4. You will pay off the loan in 5 years (perhaps due to an inheritance or an expected source of funds)
5. You think rates will generally be the same or lower for as long as you have the home

Aren’t ARMs evil?

As mortgage rates rise and ARMs become a more attractive option, there is certain to be a whirlwind of opinions about this loan product.

That’s because ARMs played a role in the mid-2000’s housing bubble that famously popped in 2008.

But we’re in a much different mortgage environment in 2022. Lending practices are stricter and borrowers are more qualified than they were 15-20 years ago. And some of the more exotic adjustable-rate products that fueled the mid-2000’s bubble are no longer offered by reputable lenders.

Today, the adjustable-rate mortgage is best described as a tool. Not Thor’s hammer that can pound any mortgage into submission, but a regular tool that performs well under the right circumstances.

ARMs come with guardrails

There are also guardrails in place that prevent adjustable rates from rising too far or too fast.

These guardrails are known as caps. They act as limiters that literally place a cap on how high the rate can rise from the introductory rate.

For example, an ARM with a 5% lifetime cap can only rise 5 percentage points from the initial rate at a maximum So an initial rate of 4% could never go above 9%.^†

Additionally, there is an initial adjustment cap that limits the first adjustment in year six of the loan. The subsequent adjustment cap limits how much the rate can rise in any given year.

2/2/5 ARM Cap example:

• The rate can’t rise more than 2% in the first adjustment
• The rate can’t rise more than 2% in any given year
• The rate can’t rise more than 5% from the introductory rate

The right tool for the time

For some homebuyers – especially first-time homebuyers on the edge of being able to qualify for a mortgage – and adjustable rate mortgage may be the right tool to achieve homeownership in today’s competitive housing market.

As mortgage rates continue to rise, more homebuyers may find themselves reaching for this tool to accomplish their goals.

^†Mortgage rate projections are not a reflection of Fairway’s opinion or guarantee of interest rates in the current or upcoming market.