Katrina Wooten has signed a contract to purchase this house that is under construction near Gainesville, Florida. Then mortgage rates rose sharply.
Katrina Wooten
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Katrina Wooten
Katrina Wooten has signed a contract to purchase this house that is under construction near Gainesville, Florida. Then mortgage rates rose sharply.
Katrina Wooten
Katrina Wooten is in the process of buying a house near Gainesville, Florida. It is still under construction and has not yet closed on a mortgage loan. But with mortgage rates doubling this year to about 6%, her monthly payments will likely be hundreds of dollars more than she originally budgeted.
“I was having panic attacks because of it,” she says. For a more affordable option, her mortgage broker has told her about considering adjustable-rate mortgages.
Many homebuyers these days are turning to adjustable rate loans because they start with a lower, more affordable interest rate. But as Wooten’s broker explained, loans come with the risk that they could eventually settle for a higher payment than a homeowner can afford.
“Adjustable-rate mortgages scare me for sure,” says Wooten. “I think about it every day.”
But rising inflation and moves by the Federal Reserve to combat it have raised mortgage rates to the highest level since 2008. That has made adjustable-rate loans more attractive, with the proportion of people applying for such loans rising the highest level in 15 years.
A lower monthly payment is the “rescue ring” that people are taking advantage of
Adjustable-rate loans can be tempting for people in Wooten’s situation, since the initial interest rate can be a percentage point lower than a fixed-rate loan.
“A percentage point can make a big difference in that monthly payment,” says Holden Lewis, who writes about mortgages for the personal finance site NerdWallet. “So they look for that rescue ring, an adjustable rate mortgage.”
Wooten has three children. And she really wants to buy the new house. “We hate where we’re living right now,” she says. “It’s a trailer, it’s falling apart.”
So Wooten, who is a nurse at a nearby VA hospital, saved up a down payment and signed a contract to buy the house for about $375,000. The whole family was excited.
“So excited…especially my 14-year-old daughter,” she says. “She’ll probably be out of my house in a few years and she’s never had a nice house to live in.”
The way most adjustable loans work these days is that they are locked in for five, seven or 10 years and then adjusted to market rates. So they definitely come with more risk than fixed rate loans.
But for some homebuyers, Lewis says it may be a risk worth taking. Plus, they’re not like the crazy adjustable mortgages that led to the home collapse: Many of them didn’t document that the homebuyer had enough income to pay off the loan, and their monthly payments skyrocketed in just two years to levels the borrower absolutely could. You can’t afford it. Those kinds of loans are now illegal.
the rate is lower why it is more risky. It’s worth it?
The reason adjustable rate loans have a lower interest rate is that the bank or lender is passing some of the risk of higher interest rates in the future to you, the owner. The lower rate is in effect your compensation for taking on that risk.
“When you get a fixed-rate loan, if mortgage rates go up after that, that’s the lender’s problem,” says Lewis. “If you get an adjustable-rate loan and mortgage rates go up, that’s your problem.”
So the question is literally can you solve take on that extra risk.
For those who can afford it, the loan can be a good financial strategy to keep costs down. Nathan Lindstrom is buying a house in Phoenix, Arizona. “We are committed to an adjustable rate, 10-year ARM, at 4%.” That means his adjustable-rate mortgage, or ARM, will have a fixed rate for the first 10 years and then adjust depending on where rates are in the market at the time.
Lindstrom is a financial professional in the healthcare industry. He has savings and investments. So if interest rates are really high in 10 years, Lindstrom has a plan.
“My wife and I could sell some of our investments to almost pay off the house,” he says.
In other words, if you have some savings and can pay off your mortgage or a large portion of it, you have a way out if rates go too high. Almost every ARMs recalculate your payment based on how much you actually owe at the point you adjust. Or you could refinance and get a new mortgage. But either way, if you owe much less on your loan, a higher interest rate will still be affordable.
Whether you can afford the risk depends on your financial situation
Another strategy is to combine a lower-interest adjustable-rate loan with paying down your principal balance more aggressively. That way, you reduce the overall size of your loan.
“No one is stopping you from paying off your principal balance faster than your minimum mortgage payments,” says Robert Heck, vice president of online mortgage broker Morty.
Heck says that ARMs are also often a good strategy for people hoping for a big increase in income. For example, a resident doctor whose salary will double or triple in 5 years after starting work as a full-fledged doctor. “They hope to earn more in the future, so this fits more with that life path.”
Anyone considering an adjustable rate loan should fully understand how these loans work and read the fine print on the particular loan you are getting.
For many homebuyers, the risk may not be worth it
The reality is that for many homebuyers who want the lowest payment on an adjustable-rate loan, the added risk is often more than they can afford because they don’t have a large income or savings.
“Maybe they need to rethink things and just buy a house that’s less expensive,” says Lewis. He says the jump in mortgage rates this year has many desperate buyers. “When you’re desperate, it’s really a good idea to step back and think about what you’re doing.”
Katrina Wooten in Florida doesn’t want to be stuck with a mortgage she can’t afford.
Wooten says he can still afford a fixed-rate loan at today’s higher rates, though it makes buying the house more difficult.
Katrina Wooten
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Katrina Wooten
Wooten says he can still afford a fixed-rate loan at today’s higher rates, though it makes buying the house more difficult.
Katrina Wooten
“I grew up poor and was the first in my family to go to college and graduate,” she says. “I have absolutely no family to turn to if this all falls apart, so it’s up to me and it has to work.”
So Wooten is walking away from an adjustable loan. She has been waiting to lock in a rate with her lender as the house gets closer to completion. But she says she’d rather make higher payments on a fixed-rate loan, even if it means living frugally for a while, so she can sleep easy at night knowing her monthly payment won’t adjust any further in the future.
She hopes rates will drop soon so she can refinance. “I just hold on to hope,” she says.