Kofi has a 7.25% fixed-rate mortgage but was recently offered a “teaser” 6.2% 5/1 adjustable rate mortgage (ARM). He’s 30 years old and living in what he considers his starter home. His career is going well, he makes an above-average income and he expects to get regular bumps in his paycheck as he climbs the corporate ladder.
Still, he’s concerned about how the policies of the current administration might affect the economy. And he’s uncertain whether it makes sense to take on an ARM amid all this uncertainty.
The lower rate of an ARM may be appealing, but there are several factors he’ll want to consider before switching. Here’s what you need to know.
An adjustable rate mortgage, or ARM, is a mortgage that starts out with a fixed rate (usually below the rate for a fixed-rate mortgage) and then the rate resets at a specified period. For example, a 5/1 ARM has a fixed rate for five years and then the rate resets each year after that.
The fixed interest rate term is commonly set at three, five, seven or 10 years.
The reset interest rate is equal to an interest rate based on an index plus a margin. For example, if the index is 4.25% and the margin is set as 1% above the index, the new rate will be 5.25%. If the index is 6% at the next reset date, the interest rate on the mortgage will be 7%.
Some indexes used to determine ARMs include the prime rate, Constant Maturity Treasuries (CMT), Cost of Funds Index (COFI), the 12-Month Treasury Average (MTA) and the Standard Overnight Financing Rate (SOFR). Most ARMs include caps on how much the interest rate can change at any reset and how high it can be set over the term of the loan.
ARMs are generally suited to people who plan to move or pay off their mortgage before the end of the fixed period. They’re also suited to those who believe interest rates will go down, but are willing to take some risk that they won’t — or who expect their income will increase enough to accommodate the potentially higher payments that may occur later.
Data shows only about 8% of Americans have ARMs; and they tend to be more popular with younger, higher-income households with big mortgages.
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In Kofi’s case, an ARM might make sense. At the lower “teaser” rate he will almost certainly reduce his mortgage payments. He’s in a starter home, so he’s likely to move before the fixed term is up. If he doesn’t move, his above-average income should help him accommodate potentially higher payments in the future.
That being said, he’s not fully comfortable with a potentially large bump in future mortgage payments and uncertainty around the economic outlook concerns him.
It’s difficult to predict the trajectory of U.S. rates as the effects of the current administration’s policies are unclear. This uncertainty in itself could result in lower business and consumer confidence, which could slow spending and the economy. Ongoing cuts to government spending have the potential to slow GDP growth, and some have argued that mass deportations could deliver a serious blow to the economy.
At the same time, the effects of tariffs are less straightforward. They have the potential to be inflationary, particularly if they’re implemented in stages rather than all at once. But if they slow the economy, they could potentially cool inflation.
Some economists are worried the current policies could create stagflation, which is when the economy experiences a slowdown and inflation simultaneously. This would make the direction of interest rates more unpredictable. The Fed might raise rates to quell inflation or it might lower them to stimulate growth.
While Kofi is well suited to an ARM, he may choose to avoid it as the floating rate takes hold. He could find he is impacted two ways by stagflation: First, rates could go up dramatically, and second, his employment or pay may be impacted if there’s a recession.
ARMs can help borrowers lower their mortgage payments over the short term — but borrowers need to be confident they can weather any financial uncertainty.
This article provides information only and should not be construed as advice. It is provided without warranty of any kind.
