The 30-year fixed-rate mortgage has long been a tradition in the U.S., but for many millennials buying homes, this old-hat loan product just won’t cut it anymore. Instead, this cohort is gravitating toward a historically less-used product: the adjustable-rate mortgage.
Offering lower upfront costs and the flexibility to up and move without taking a huge financial hit, adjustable mortgages (also called ARMs) are often just what the career-focused, on-the-move millennial is looking for.
The chart below shows the average mortgage rates from 2005 through today, broken down into 5/1 ARMs, 15-year fixed mortgages, and 30-year fixed mortgages.
What Is an Adjustable Rate Mortgage?
Adjustable-rate mortgages are loans on which the interest rate fluctuates. The borrower is charged a set interest rate for a certain number of years, and when that fixed period expires, the interest rate can go up or down depending on the index it’s tied to.
Fixed periods on ARMs usually last 3, 5, 7, or 10 years, though the longer the fixed period is, the higher the interest rate will usually be. For example, a 5/1 ARM might come with a 4% interest rate, while a 3/1 loan will come with a 3.75% one.
Millennials and ARMs
Adjustable-rate loans only make up a small share of overall mortgage activity (about 8% as of February 2019, according to the Mortgage Bankers Association), but they’re on the rise with millennials. John Walsh, the chairman of Total Mortgage Services, recently told the Wall Street Journal that the number of millennials opting for 7/1 ARMs jumped 18% over the last year.
It’s no wonder either. As most millennials are first-time buyers, using an ARM over a fixed-rate product could increase buying power by tens of thousands of dollars, according to Odeta Kushi, deputy chief economist for First American. “At current rates, an ARM increases consumer house-buying power by approximately $30,000 compared with a traditional 30-year, fixed-rate mortgage. This could be a game-changer for many first-time homebuyers.”
According to data from mortgage technology provider Ellie Mae, 34% of all adjustable-rate mortgages went to millennial buyers in 2018. The share has climbed steadily since 2014, when only 18% of ARMs went to millennials.
ARM Benefits for Millennials
- Lower interest rates
- Lower monthly payments
- Lower up-front costs
- Allows for a larger, more expensive home purchase
- More flexibility to move
- More cash flow to save and invest elsewhere
- The potential for interest rate increases
- The potential for higher monthly payments
- May require a refinance shortly after buying
- Often come with pre-payment penalties
- Complicated for first-time buyers
There are lots of advantages that come with adjustable-rate mortgages. Compared to fixed-rate products, they offer lower rates, lower monthly payments, and lower costs at the start of the loan. For many millennials, this can help put homeownership within reach—especially if they’re dealing with student loan debt or don’t have much in savings.
The other big benefit is that ARMs make it easier to up and move for a career change or to a larger property a few years down the line. With fixed-rate loans, you’re paying mostly interest for the first couple of years—and it’s a higher interest rate at that. This means if you sell your home just a few years after buying it, you’ll have spent much more in interest than you would have on an ARM. Consequently, you also won’t have much equity in the property, so you won’t net very much in profit on the sale either.
There are, of course, disadvantages to using an adjustable-rate loan. For one, if you stay longer than your fixed period, your rate could increase, sending your monthly payment up with it. There’s always the chance you could refinance in this case, but there’s no telling if rates will be favorable or if you’ll have enough equity in your home to make it worthwhile.
There’s always the chance that rates drop once the fixed period of an ARM expires. If this happens, then the borrower would enjoy a lower rate and a lower monthly payment without the hassle of refinancing.
Is an ARM Right for You?
For millennials buying homes, choosing the right loan product is crucial. Think about your long-term plans and select a mortgage that aligns with your goals. If you don’t intend to stay in the home for more than four years, a 5/1 ARM will offer you the biggest rate advantage and the most in saved interest. If you plan to stay in the home for the long haul, a fixed-rate mortgage is probably your best bet.
In the event you do choose an ARM product, make sure to read the fine print. Most lenders will put an annual and lifetime cap on how much your rate can increase. Knowing this maximum can help you financially prepare in the event your rate goes up.