Housing News

What Lower Interest Rates Mean for Adjustable-Rate Mortgages

Mortgage interest rates have been on a bit of a rollercoaster in the last few years. After falling to all-time lows in 2021, rates then whipsawed back up to their highest level in more than a decade in late 2022.

That rise pushed many people to turn to an adjustable-rate mortgage (ARM), which typically offers lower rates for the first five, seven or 10 years of the loan compared to fixed-rate mortgages. Those lower rates make buying a home more affordable, but those rates are also temporary.

So, what happens when the interest rate resets after that initial period? Well, it depends on where rates are at that point. In some cases, short-term interest rates, such as the ones used for ARMs, are higher than longer-term rates.

Dusty Lloyd, a New American Funding loan officer in Dana Point, Calif., recently worked with a client who had a $1 million ARM at 5.99%.

“His rate was about to jump to 7.99%, and it could’ve gone as high as 10.99% if short-term rates stayed high,” Lloyd said. “We were able to lock him into a much lower rate with a new 30-year fixed mortgage.”

For those who took out an ARM when short-term rates were much lower, it might be a good time to revisit their mortgage terms. When is the ARM set to adjust? If it's soon, their payment could increase, depending on where short-term rates are at the time.

However, thanks to the recent drop in long-term interest rates, refinancing into a fixed-rate loan could save thousands and provide peace of mind, ensuring that the payments won’t spike. That makes now a good time to consider locking in a lower, stable rate.

What are ARMs and how do they work?

ARMs are attractive to certain borrowers as they typically offer lower interest rates for a for a set period. However, once that “honeymoon” low-rate period ends, the rate adjusts based on current market conditions. If short-term rates go up, so will the monthly payment.

That means the monthly payments will change every year after the introductory period.

There are a several popular ARM options.

A 5/1 ARM offers a fixed rate for the first five years. There are also 7/1 and 10/1 ARMs with introductory periods of seven and 10 years, respectively.

Other ARMs reset more frequently, like 7/6 ARMs. These loans lock in the interest rate for the first 7 years but adjust every six months after that.

Beyond the desire to find savings in the market based on where long-term interest rates are, some people choose an ARM if they know they are not going to stay in their home for an extended period of time.

For example, if they plan to move within five years, an ARM could make sense to give them a lower interest rate than the 30-year mortgage rate.

But for those who are still in their introductory period, or their life plans have changed, it may make sense to review their mortgage options based on where the market is now.

“Many people took out ARMs 5-10 years ago when short-term rates were lower than fixed rates. These loans can adjust by up to 2% annually and increase by a total of 5-6% over time,” said Lloyd.

Before the pandemic, ARM rates were often between 3% and 4%, according to Freddie Mac. They even dropped below 2.5% in 2021, making them attractive. But things have changed.

As of September 2024, the rate for a 5/1 ARM is around 5.8%, and a 7/6 ARM is 6.14%, according to The Mortgage Reports. However, both of those are now higher than the rates for a 30-year or 15-year fixed mortgages.

What’s Driving ARM Rates Higher?

ARM rates are primarily affected by market conditions and the actions of the U.S. Federal Reserve.

Currently, the Federal Reserve is keeping short-term interest rates high to manage inflation. This is driving up the cost of borrowing. When the Fed raises its benchmark rate, it makes loans like ARMs more expensive, as the rates adjust based on these short-term market changes.

Besides Federal Reserve policies, factors like inflation, economic growth, and global market conditions also contribute to the rising ARM rates. As inflation remains a concern, lenders are increasing interest rates to protect against future risk, causing adjustable rates to rise faster than they would in a more stable economic environment.

If the Fed lowers short-term rates in the future, ARMs could become more attractive again, especially if those rates drop below the rates for fixed mortgages.

But for now, this is why homeowners with ARMs are likely seeing their rates increase and why fixed-rate mortgages are now offering better long-term stability.

Is Refinancing Right for You?

If your ARM is nearing its adjustment period, refinancing to a fixed-rate mortgage may be something to look into, especially if you're concerned about rising rates and higher payments.

However, before moving forward, it's important to factor in the costs of refinancing, such as closing costs and other lender fees, and weigh them against the potential long-term savings. Each person’s situation is different and it’s important to make the best decision for you.

Consulting a mortgage professional can help you assess the pros and cons and determine the best course of action for your financial situation.

^{Dusty Lloyd NMLS # 247106}