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Adjustable rate mortgages can be cheaper but risky. Here's what you need to know

Katrina Wooten signed a contract to buy this home that's under construction near Gainesville, Fla. Then mortgage rates jumped sharply higher.
Katrina Wooten
Katrina Wooten signed a contract to buy this home that's under construction near Gainesville, Fla. Then mortgage rates jumped sharply higher.

Katrina Wooten is in the process of buying a house near Gainesville, Florida. It's still under construction and she hasn't yet locked a home loan. But with mortgage rates doubling this year to around 6%, her monthly payments will likely be hundreds of dollars more than she'd originally budgeted for.

"I was having panic attacks over it," she says. For a more affordable option, her mortgage broker has talked to her about considering adjustable rate mortgages.

A lot of homebuyers these days are turning to adjustable rate loans because they start out with a lower, more affordable interest rate. But as Wooten's broker explained to her, the loans come with the risk that they can eventually adjust to a higher payment than a homeowner can afford.

"Adjustable rate mortgages scare me for sure," says Wooten. "I think about it every day."

But higher inflation and the Federal Reserve's moves to fight it have pushed up mortgage rates to the highest level since 2008. That's made adjustable rate loans more attractive, with the share of people applying for such loans at the highest level in 15 years.

A lower monthly payment is the "rescue ring" people are grasping

Adjustable rate loans can be tantalizing for people in Wooten's situation, as that initial interest rate can be a full percentage point lower than a fixed rate loan.

"A percentage point can make a really, really big difference in that monthly payment," says Holden Lewis who writes about mortgages for the personal finance site NerdWallet. "So they grasp for that rescue ring, an adjustable rate mortgage."

Wooten has three kids. 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's a nurse at a nearby V.A. hospital, saved up a downpayment and signed a contract to buy the home for about $375,000. The whole family was excited.

"So excited...especially my 14-year-old," she says. "He's going to be out of my house probably in a few years and he's never really had a nice house to live in."

The way most adjustable loans work these days is that they're fixed for either five, seven, or 10 years and then they adjust to wherever rates are in the market. So they definitely come with more risk than fixed rate loans.

But for some homebuyers, Lewis says that can be a risk worth taking. Also they aren't like the crazy adjustable mortgages that led to the housing crash — many of those didn't document that the homebuyer had enough income to repay the loan, and their monthly payments exploded in barely two years to levels the borrower absolutely couldn't afford. Those kinds of loans are now illegal.

The rate is lower because it's riskier. Is it worth it?

The reason adjustable rate loans have a lower interest rate is that the bank or lender is passing on some of the risk of higher interest rates in the future to you the homeowner. The lower rate is in effect your compensation for taking on that risk.

"When you get a fixed rate loan, if mortgage rates rise after that, that's the lender's problem," says Lewis. "If you get an adjustable rate loan and mortgage rates rise, that's your problem."

So the question becomes, quite literally, can you afford to take on that added risk.

For those who can afford it, the loan can be a good financial strategy to keep costs low. Nathan Lindstrom is buying a house in Phoenix, Arizona. "We are locked in with 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 then.

Lindstrom is a financial professional in the healthcare industry. He has savings and investments. And so if interest rates are really high in 10 years, Lindstrom has a plan.

"My wife and I would be able to sell off some of our investments to almost completely pay off the house," he says.

In other words, if you have some savings and can afford to pay off your mortgage or a big chunk of it, you have a way out if rates go up a lot. Almost all ARMs recalculate your payment based on how much you actually owe at the point it adjusts. Or you could refinance and get a new mortgage. But either way, if you owe a much smaller amount 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 your overall loan size.

"Nobody's stopping you from paying down your principal balance faster than what the minimum payments are on your mortgage," says Robert Heck a vice president at the online mortgage broker Morty.

Heck says ARMs also are often a good strategy for people who expect a big increase in their income. For example, a medical resident whose salary will double or triple in 5 years after they start working as a full-fledged doctor. "They expect to earn more in the future, and so this fits more with that life path."

Anyone considering an adjustable rate loan should understand fully how these loans work, and read the fine print on the particular loan you get.

For many homebuyers, the risk may not be worth it

The reality is that for many homebuyers who want the lower payment of an adjustable rate loan, the added risk is often more than they can afford to take because they don't have a big income or vast savings.

"Maybe they need to rethink things and just shop for a house that's less expensive," says Lewis. He says the jump in mortgage rates this year has many homebuyers feeling desperate. "When you're desperate, it really is a good idea to step back and think about what you're doing."

Katrina Wooten in Florida doesn't want to get stuck with a mortgage she can't afford.

Wooten says she can still afford a fixed rate loan at todays higher rates, even though it makes buying the house more of a stretch.
/ Katrina Wooten
Katrina Wooten
Wooten says she can still afford a fixed rate loan at todays higher rates, even though it makes buying the house more of a stretch.

"I did grow up poor and was the first one in my family to go to college and graduate," she says. "I absolutely don't have any family to turn to if this all falls apart, so it's on me and it's got to work out."

So Wooten is leaning away from an adjustable loan. She's been waiting to lock in a rate with her lender as the house is closer to being completed. But she says she'd rather make the 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 higher down the road.

She hopes rates will then fall before too long so she can refinance. "I'm just holding on to hope," she says.

Copyright 2022 NPR. To see more, visit https://www.npr.org.

NPR correspondent Chris Arnold is based in Boston. His reports are heard regularly on NPR's award-winning newsmagazines Morning Edition, All Things Considered, and Weekend Edition. He joined NPR in 1996 and was based in San Francisco before moving to Boston in 2001.
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