Adjustable-rate mortgages are on the rise for prospective home buyers. While some borrowers can take advantage of this, for the majority of borrowers, an adjustable rate mortgage might be a risky investment that could lead to trouble in the future.
The Los Angeles County Department of Consumer and Business Affairs encourages all prospective buyers to consider all the facts and know the risks and benefits as you search for the home loan product that fits your needs.
The rise in interest rates has pushed more and more people to consider short-term affordable financing options, like adjustable-rate mortgages (ARMs). At the beginning of 2022, just three percent of home loans were ARMs. Now, it’s nearly 11 percent, the highest it has been since 2008 when risky mortgages contributed to the global economic crisis.
Fixed-interest vs. adjustable-rate mortgages
A fixed-interest mortgage will have a singular interest rate for the life of the loan. The rate is determined when you get the loan and depends heavily on the market, your credit worthiness, and debt-to-income ratio.
An adjustable-rate mortgage has an interest rate that changes. ARMs often start with a lower monthly payment than fixed-rate mortgages, but your monthly payment may increase. All ARM loans have adjustment periods which determine how often an interest rate can change. Most ARM loans also have a limit as to how much an interest rate can change. Depending on the terms of your mortgage and market conditions, ARM payments can fluctuate drastically over the life of the loan- so while you may save money initially, you could face much higher payments in the future.
For example, a 5/1 ARM (often advertised as a hybrid ARM) would allow for the initial interest rate to remain the same for the first five years of the loan, making the sixth year the first year an interest rate is eligible to adjust. The same principle applies to 3/1 ARMs and 7/1 ARMs.
Tips for Prospective Borrowers
Borrowers should keep in mind the following when considering a home loan:
- Shop around for the best loan product that fits your needs. When working with a professional, ensure that you’re working with a licensed broker, mortgage banker, or financial institution. To check a mortgage loan originator’s license and registration status, visit nmlsconsumeraccess.org.
- If you’re considering keeping the home for longer than the fixed-rate period, it may be wise to explore refinancing the loan to a fixed rate to avoid drastic changes in the monthly mortgage payment.
- If you are planning on living in a property for a short time and plan to sell the property before the loan reached the first interest rate adjustment, an ARM loan might work for you.
- If you get a “Pay Option ARM,” know all the details. With a Pay Option ARM, you will have different payment options every month. Generally, Pay Option ARM’s will have a fully amortizing payment, an interest-only payment, and a minimum payment. Caution: Making the minimum payment will not be enough to cover the interest portion for that given month and any shortfall will be added to the principal. You could end up owing more money than you borrowed. This is known as a “Negative Amortizing” or “Neg Am” loan.
- Some ARMs may have a pre-payment penalty. If you decide to pay off the loan early (within the first three years), you may incur a fee equal to six months of interest.
DCBA can help
To better understand your rights and responsibilities as a homeowner, you can speak with one of our Foreclosure Prevention counselors, by calling (800) 593-8222. Visit our website for more information.