This is how you know if the popular adjustable rate loan is right for you

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Adjustable rate loans are on the way back.

With rising interest rates, more buyers are turning to ARMs, which offer lower starting rates than fixed-rate loans. However, after a certain period, the price of ARM is adjusted to reflect current market conditions.

“You have twice as many borrowers out there applying for ARMs in the last four months because of how fast rates have come up,” said Joel Kan, associate vice president of economic and industrial forecasting at the Mortgage Bankers Association.

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The interest rate on a 30-year fixed-rate mortgage is 5.41%, according to Mortgage News Daily. Meanwhile, the rate for a 5/1 ARM is 4.38%. “5” means that the rate is fixed for five years, and “1” means that it is then adjusted once a year for the remaining term of the loan.

“Obviously, people are looking for other options when it comes to financing their home because they are competing with other borrowers and they are probably looking to secure the home they want, given how tight the housing stock is,” he said. Able to.

How ARMs work

There are different time frames available for the fixed portion of the loan: generally three, five, seven and 10 years. The conversion period can be one year or six months, which would be similar to 7/1 or 7/6 for a seven-year ARM, respectively.

There are also ceilings for the interest rate, which means that there is a maximum amount that the interest rate can rise or fall each time, as well as a maximum ceiling for life. For example, if you have a 5% lifetime limit on your 5/1 ARM, your 4.38% rate could end up at 9.38%.

Make sure you know how much higher the interest rate on your loan can be and what it means for your monthly payment and its impact on your budget.

Danielle Hale

Chief economist at Realtor.com

That is why it is so important to understand the specific terms of the loans you are considering.

“Using an adjustable rate loan may make sense in some situations, but it’s a more sophisticated mortgage product,” said Danielle Hale, chief economist at Realtor.com.

“Buyers who are considering it want to make sure they understand the pros, cons and risks.”

Weighing your options

ARMs are not nearly as popular as they were during the subprime credit crunch of the mid-2000s, when credit standards were lax and many borrowers ended up in trouble. These days, credit standards are much higher and underwriting is extremely tight, Kan said.

“We are not looking at the same kind of risks that we did back then,” he said.

That said, if you take out an adjustable rate loan, you may end up with a significantly higher interest rate than a fixed rate loan.

Therefore, if you are considering an ARM, think about how long you plan to stay in the home.

“It can make sense for people looking at a short timeline,” said certified financial planner Diahann Lassus, CEO of Peapack Private Wealth Management in New Providence, New Jersey.

“They want to buy a house, but will probably move in three to five years,” she added. “If they can lock in a five-year ARM, it can help them reduce their costs and sell in five years before the interest rate is recalculated.”

It can also provide work for someone who will pay off the loan in a relatively short amount of time, such as those who are waiting to sell their previous home and then use the proceeds for the new home, said Lassus, a member of the CNBC Financial Advisor Board.

Keep in mind, though, that plans may change or you may not be able to sell your home when you want to. If you end up keeping the loan past its original fixed interest rate and the rate rises, you end up with increased monthly payment.

“Make sure you know how much higher the interest rates on your loan can go and what it means for your monthly payment and its impact on your budget,” said Realtor.com’s Hale.

Of course, ARM interest rates may also fall if mortgage rates fall.

Witthaya Prasongsin | Moment | Getty Images

“When a fall in mortgage rates is expected, adjustable-rate loans are typically offered with less discount and very rarely even a premium on fixed-rate mortgages,” she explained.

Lassus advises anyone planning to stay longer than the term of the fixed rate on an ARM to stick to traditional fixed rate loans.

Of course, housing prices are also high, making affordability a factor for many. For those who can wait, be patient and wait for the right opportunity, she advises.

Also, keep in mind that fixed mortgage rates around 5% are still reasonable, historically speaking, Lassus pointed out.

“We’ve been living in this really, really cheap mortgage era, and it’s changed our perspective,” she said.

“It will take a while to get used to the higher mortgage rates and what that means.”

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