I’m Considering This Surprising Move to Save Money on a Mortgage

It’s finally time — I’m officially house hunting. I have a real estate agent, and while the market is quite sluggish in my city at present, I hope things will pick up as spring comes out of hiding. I did my due diligence and shopped around with several mortgage lenders.

Mortgage rates are a source of frustration for me — Freddie Mac notes that the average rate on a 30-year fixed mortgage is currently 6.74%. But one of the mortgage people I talked to is a broker — he’s tasked with matching buyers to mortgages offered by banks and credit unions. He noted that a local credit union has adjustable rate mortgages (ARMs) available for about 1 percentage point lower than a fixed mortgage.

However, my natural cautiousness and desire to make this experience with homeownership better than my last one has me wondering if this is the right move. Let’s take a closer look at ARMs, as well as their less-than-sterling reputation, to decide if they’re a good idea.

What can an ARM do for you?

In short, you might be able to save money on mortgage interest with an ARM. When you get a 30-year fixed-rate mortgage, the rate is just that — fixed for the entire 30 years of your term. You are of course free to refinance that mortgage, ideally to a lower rate, at any point. And you can also switch the term of your mortgage, turning a 30-year mortgage into, say, a 15-year one.

But ARMs are different. Three common types are called 5/1, 7/1, and 10/1 (and these were the types pitched to me by the mortgage broker). The first number is how long your initial rate will stay the same, in years — five years, seven years, or 10 years. The second number is how often the rate can change (adjust) after that. So for a 5/1 ARM, you get the same rate for the first five years, then once a year thereafter, your mortgage rate can change.

Who are ARMs best for?

My colleague Matt Frankel recently wrote about ARMs and discussed the buyers they might be right for:

  • Buyers who don’t intend to stay in the house long enough for their mortgage rate to adjust — if you sell before the rate changes, you’re not at risk of paying more.
  • Buyers with lower credit scores who are actively working to improve them, so they can qualify for a better rate on a fixed-rate refinance loan.

As a survivor of 35 moves, I am sincerely hoping to move into the house I buy and stay put for a good long while (ideally more than five years). And my credit score is already over 800 — I intend to keep it that way, which means that when (if?) mortgage rates go down, I shouldn’t struggle to refinance my mortgage to a lower rate.

If you fit into either (or both) of these categories of home buyer, it might be worth considering an adjustable-rate mortgage as you’re shopping around. You might find, as I did, that the rates on them are significantly lower than fixed rates.

Exercise caution with adjustable-rate mortgages

I referenced the dodgy reputation of ARMs above. A lot of people associate ARMs with the 2008 Great Recession and the subprime mortgage crisis, but this might be overstating things just a bit.

Leading up to 2008, many Americans who could not afford to buy homes (due to their credit, debt, or lack of income) ended up with ARMs. Some of them came with “teaser rates” that were lower for two or three years, then shot up. These loans sometimes also came with negative amortization, meaning that early payments didn’t fully cover the payment amount plus interest owed — and the loan balance grew as a result.

Thankfully, guardrails for borrower income verification put in place after 2008 have made today’s ARMs less risky, and the type of borrowers using them are different now. In fact, the Urban Institute’s data analysis found that 2022 ARM borrowers actually had higher credit scores than fixed-rate borrowers, for example.

Is an ARM right for you?

If you decide to buy with an ARM, there are a few ways to ensure you won’t be making a huge and expensive mistake. For starters, really dig into your budget and decide how much you’re comfortable spending every month on predictable housing costs (mortgage payment, interest, taxes, insurance, or PITI). For me, that figure is double what I currently pay for rent and renters insurance.

Since I know how much I want to spend every month, I can put a given house’s price into The Motley Fool Ascent’s mortgage calculator and see an estimate of what I’d be paying. Regardless of your own budget, it’s best to keep your predictable monthly housing costs below 30% of your income.

I’m leaning toward the 7/1 or 10/1 ARM, because five years is not very long, especially with as much turmoil as we’ve seen in just the last four years of the mortgage market. If I have seven or 10 years with a lower rate than I could get with a fixed mortgage, it’s my hope to pay extra toward my home’s principal and have a significantly lower balance to refinance when the time comes.

Is an ARM right for me? It might be — I haven’t even found a house worth making an offer on yet, so I can kick this decision down the road a bit. Are they right for you? Run your own numbers to decide.

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