Why ARMs Can Be Good for First-Time Homebuyers

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Credit Sesame discusses the possible benefits of adjustable rate mortgages for first-time homebuyers.

Tax benefits, equity building, freedom and stability are a few of the reasons to own a home listed by the National Association of Realtors. You can live in the same spot for as long as you want without worrying if the landlord is going to raise the rent. Your monthly mortgage payment is predictable if you get a fixed-rate mortgage, as many homebuyers do.

An adjustable-rate mortgage (ARM), however, can make buying a home cheaper and may be a good option for first-time homebuyers.

What is an adjustable-rate mortgage?

A fixed-rate home loan has an interest rate that never changes for the duration of the loan, usually 15 or 30 years. An adjustable-rate mortgage is a home loan that has a fixed interest rate that’s low for a set time, then can change once or twice a year.

ARMs have a fixed rate for a five, seven or 10-year introductory period. Typically, the rates are around one percentage point lower than for a fixed-rate mortgage. After the intro period, the ARM rate can change every six months or once a year, depending on the conditions of the loan. The changing interest rate is tied to an index, such as the 1-year Treasury Security, or the London Interbank Offered Rate (LIBOR.)

For a 5/1 ARM, the 5 indicates a five-year introductory period where the interest rate stays the same. The 1 indicates how often the rate can change for the life of the loan. In this case, it means once a year. A 5/6 ARM is fixed for 5 years and may then adjust every six months. ARMs have caps on how much interest can be adjusted in any period and over the lifetime of the loan.

As with fixed-rate mortgages, borrowers may be able to end an adjustable-rate mortgage by paying off the loan, refinancing, or selling their home.

Difference in 5-year payments for fixed versus ARM

The obvious appeal of an ARM is that usually they have lower interest rates than fixed-rate mortgages during the introductory period. A lower interest rate can save you thousands of dollars in five years. For example, a $240,000 loan shows that over five years payments for a fixed-rate loan total $96,600. whereas payments on an ARM total $85,980, a difference of $10,620 (or $2,124 per year or $177 per month).

Loan termInterest rateMonthly payment5-year total
30-year fixed7.08%$1,610$96,600
5/6 ARM5.96%$1,433$85,980

The interest rates used are for the week ending October 27, 2022 reported by Freddie Mac in its Primary Mortgage Market Survey.

How low are ARM interest rates??

The last week in October 2022 is the first time in 20 years that the 30-year fixed-rate mortgage broke 7%. As interest rates on fixed-rate mortgages have increased, so have ARMs.

Mortgage typeJanuaryJulyOctober
Fixed rate3.22%5.30%7.08%
5/1 ARM2.41%4.19%5.96%

Even as rates more than doubled this year, ARMs have stayed around a percentage point below fixed mortgage rates. Since 2000, ARM rates have consistently been lower than fixed rates on average, according to the Mortgage Bankers Association

Not surprisingly, ARMs are gaining market share again as fixed-rate mortgages hit 20-year highs. ARMs account for 10% of mortgages in 2022, up from 5% in 2015.

Five-year ARMs usually have the lowest interest rates and monthly payments during the initial rate period. Ten-year ARMs have higher rates in exchange for longer protection from interest rate changes.

Why first-time homebuyers might consider ARMs

Many people think their first home is where they’ll live forever. According to Home LLC 43% of home buyers assume they’ll stay in their homes for at least 16 years. In fact, more than 60% of people under age 38 stay in their homes for under eight years.

The reasons for moving are numerous, including a new job, a growing family that needs more space, moving closer to loved ones, and selling a home that appreciates in value so owners can upgrade to a new home. Whatever the reason, new homebuyers may benefit from adjustable-rate mortgages that give more financial possibilities. Lower rates on an ARM may mean:

  • Less pressure on cashflow
  • The principal can be paid down faster
  • Money may be added to retirement savings
  • Being able to increase the loan amount and buy a larger house

How risky are ARMs?

The downside of an ARM is that after the introductory period, the interest rate can be adjusted, perhaps higher than a fixed-rate mortgage. However, there are limits to how much interest rates can rise for ARMs. Buyers should always check the lender-specific terms and conditions, but most ARMs have three types of rate caps that protect consumers:

  1. Initial adjustment cap. At the end of the fixed-rate period, the first time the rate adjusts it can only be 2% or 5% higher than the initial rate, according to the Consumer Financial Protection Bureau. No matter how high interest rates have risen, the initial adjustment cannot exceed this cap.
  2. Subsequent adjustment cap. After the initial adjustment, the rate can only increase by a certain amount each year. The most common cap is two percentage points higher than the previous rate, the CFPB says.
  3. Lifetime adjustment cap. Over the life of the mortgage a cap is set on the total increase over the life of the loan. This is often up to 5% higher than the initial rate, though some lenders may have a higher cap.

Cap rates should be compared when looking at ARMs, even if you think you’ll move or refinance before the adjustable period starts.

The CFPB also recommends that applicants ask lenders to calculate the highest payment they’ll ever have to pay on the loan they’re considering. This information should be in the Truth-in-Lending disclosure after applying for a loan.

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Disclaimer: The article and information provided here is for informational purposes only and is not intended as a substitute for professional advice.

Aaron Crowe
Aaron Crowe is a freelance journalist who specializes in personal finance topics. He has written for Wise Bread, AOL, AARP, Bankrate and other websites that focus on financial literacy and saving money. He has also worked as a newspaper reporter and editor. You can follow him on Twitter @AaronCrowe.

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