Are ARMs Still Attractive Mortgage Options?

Read Time: 5 minutes

For many years one of the best available mortgage options was the basic ARM — an adjustable-rate mortgage. Not the most popular, but in some ways attractive. One reason: Luck.

Mortgage rates generally fell from 1981 through January 2021, going from 18.63% to just 2.65%. Falling rates eliminated the biggest risk represented by ARMs.

Since rates were largely going down, borrowers did not face the threat of massive payment increases when their loans adjusted. This means ARM borrowers started out with a rate below comparable fixed-rate financing, and then benefited as interest levels largely declined over time.

Nobody knew rates would gradually fall for a period of 40 years and now things have changed. Recent rate levels have increased, going from 2.65% in January 2021 to 6.86% at the end of June 2024.

Such steeper interest levels raise a question: Just how badly have recent ARM borrowers been hurt by rising rates, if at all?

2019 Mortgage Options

If we go back to June 2019 — five years ago and just before the pandemic — 30-year, fixed-rate mortgages were available at 3.73% while 5/1 ARMs were priced at 3.39%, according to Freddie Mac. Generations of mortgage borrowers who paid far higher rates would have jumped at 3.73% financing and ignored the ARM option and the risk of higher monthly payments.

But, no doubt, some folks took the ARM, and now we can see what happened with such loans when mortgage rates rose. 

The monthly cost for principal and interest is $1,386 if we borrow $300,000 at 3.73% over 30 years. That’s it.

That monthly cost will remain steady whether future interest rates go up or down. This means a fixed-rate mortgage is a great hedge against inflation. 

A 5/1 ARM works differently. 

First, there is a five-year start period with a fixed rate, 3.39% in this case. The initial monthly payment with a $300,000 mortgage is $1,329. The ARM borrower is saving $57 a month for 60 months, or $3,420.

Second, after the start period ends, the rate and monthly payments adjust annually. How much rates can rise or fall is determined in the ARM agreement.

For example, with a 2/2/5 cap arrangement, the rate can rise as much as 2% at the first reset, 2% each year thereafter, but not more than 5% above the 3.39% start rate. The movement of the rate up or down is tied to an index such as the Constant Maturity Treasury (CMT) rate or the prime rate.

Take the index, add a fixed-rate “margin” and you get the ARM interest rate. For instance, if an index is at 3% and the margin is 2% the interest rate will be 5%. If the index moves to 2% and the margin is 2%, the interest rate will be 4%.

If our model ARM rate goes up the full 2% at the first reset, then the new rate after five years is 5.39%. However, this rate is not applied to the $300,000 initial loan balance.

It’s calculated on the basis of the remaining mortgage amount — $268,580 in this case — and the remaining loan term, 300 months or 25 years. The new monthly ARM payment after five years in this example is $1,632, an increase of $303 a month ($1,632 less $1,329), an extra $3,636 per year, and more than fixed-rate borrowers are paying.

For many households, $3,600 in higher costs is a big deal, but we’re not talking about just any households. We’re instead talking about buyers who could afford a $300,000 mortgage five years ago, individuals who went through the loan application process and qualified for financing.

Equally important, 5.39% is well below the 6.86% fixed-rate interest level seen in mid-2024. 

The DTI Factor

While an ARM was not the choice most of us would have made in 2019, it may well have been an attractive financing option for buyers who needed to purchase. That’s because the smaller monthly payment produces a lower debt-to-income ratio (DTI), one more likely acceptable to mortgage lenders.

In other words, borrowers with marginal incomes might not have qualified for financing and been able to buy without the lower monthly costs of an ARM. They might still be renters and generally owners have done better financially.

According to the Federal Reserve, in 2022 owners had a $396,200 median net worth versus $10,400 for renters.

Buying a home in 2019 turned out to be a good choice for most purchasers. Really good.

According to the National Association of Realtors (NAR), the typical existing home sold for $277,700 in May 2019 versus $419,000 in May of this year, an equity increase of more than $140,000.

However, no one can guarantee rising home values. Like stock prices, real estate values can go up and down. As an example, NAR reported that in the first quarter 205 metro areas had rising prices while 15 saw values decline.

Most 2019 ARMs Have Not Adjusted

An ARM start period does not have to be five years, and it usually isn’t. According to ICE Mortgage Technology’s June ICE Mortgage Monitor Report, “77% of active ARM loans originated over the past five years operate as fixed-rate mortgages for at least the first five years, 63% are fixed for at least seven years, and more than a third are fixed for the first 10 years.”

In other words, most ARM borrowers from 2019 are still making payments at their original cost, but for some that’s about to change.

According to ICE, “Of the 1.75 million active ARM loans originated since 2019, only 328,000 are in their adjustable phase, with 102,000 expected to see their first reset over the next 12 months, signifying relatively low risk due to first-time rate resets.”

Future Rates, Future Results

What will happen in two years or so, when many 2019 ARM borrowers are most likely to see their loans reset?

We don’t know where rates will be in two years (or next week), but it’s a good bet they’ll be higher than in 2019. That’s because rates below 4% are an outright oddity.

According to data from Freddie Mac, the average mortgage rate between April 1971 and June 2024 was 7.73%.

It’s also a good bet that even with higher rates, ARM borrowers by and large will be just fine. They’ll owe less in two years because of amortization and that holds down monthly costs.

They may also have substantial equity they didn’t have in 2019. Plus, like many households they may have higher incomes to offset larger mortgage payments. Think of it as more good luck if all goes right.

Peter G. Miller

Peter G. Miller is a nationally-syndicated columnist, the author of seven books published originally by Harper & Row (including one with a co-author), and has contributed to leading online sites and major print publications. He has appeared on numerous media outlets including the Today Show, Oprah!, CNN, and NPR.

Peter has been an accredited correspondent on Capitol Hill and a member of the White House Correspondents Association. He has served with the District of Columbia National Guard and holds both BA and MS degrees from The American University in Washington, DC. View Peter on LinkedIn.

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