Variable rate mortgages can be cheaper, but risky. Here’s what you need to know

Katrina Wooten is buying a house near Gainesville, Florida. It’s still under construction and she hasn’t gotten a mortgage yet. But with mortgage rates doubling this year to around 6%, her monthly payments will likely be hundreds of dollars more than she originally expected.

“I had panic attacks because of it,” she says. For a more affordable option, her mortgage broker talked her into considering adjustable rate mortgages.

Many homebuyers are turning to variable rate loans these days because they start with a lower, more affordable interest rate. But as Wooten’s broker explained to him, loans come with the risk that they could eventually accommodate a higher payment than a homeowner can afford.

“Adjustable rate mortgages scare me,” says Wooten. “I think about it every day.”

But rising inflation and action by the Federal Reserve to combat it have pushed mortgage rates to the highest level since 2008. This has 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 circle” people grab

Variable rate loans can be enticing for people in Wooten’s situation because that initial interest rate can be one 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 personal finance site NerdWallet. “So they’re grabbing for that bailout ring, an adjustable rate mortgage.”

Wooten has three children. And she really wants to buy the new house. “We hate where we live 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 around $375,000. The whole family was delighted.

“So excited…especially my 14-year-old daughter,” she said. “He’s probably going to leave my house 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 are fixed for five, seven or 10 years and then adjust to market rates. They therefore certainly involve more risk than fixed rate loans.

But for some buyers, Lewis says that may be a risk worth taking. Plus, they’re not like the crazy adjustable mortgages that led to the housing crash – many of them didn’t document that the buyer had enough income to pay off the loan, and their monthly payments skyrocketed in just a few minutes. two years at levels that the borrower absolutely could not afford. These types of loans are now illegal.

The rate is lower because it’s more risky. Is it worth it?

The reason variable rate loans have a lower interest rate is that the bank or lender passes some of the risk of higher interest rates in the future onto the homeowner. The lower rate is actually your compensation for assuming that risk.

“When you get a fixed rate loan, if mortgage rates go up after that, that’s the lender’s problem,” Lewis says. “If you get an adjustable rate loan and mortgage rates go up, that’s your problem.”

So the question becomes, literally, can you afford take that extra risk.

For those who can afford it, the loan can be a good financial strategy to keep costs down. Nathan Lindstrom buys a house in Phoenix, Arizona. “We’re stuck with an adjustable rate, 10-year ARM, at 4%.” This means that his variable rate mortgage, or ARM, will have a fixed rate for the first 10 years and then adjust based on where rates are then in the market.

Lindstrom is a healthcare finance professional. He has savings and investments. And so if interest rates are really high 10 years from now, Lindstrom has a plan.

“My wife and I could sell some of our investments to pay off the house almost entirely,” he says.

In other words, if you have savings and can afford to pay off your mortgage or a large portion of it, you have a way out if rates go up a lot. Almost all ARMs recalculate your payment based on the amount you actually owe at the time it adjusts. Or you could refinance and get a new mortgage. But either way, if you owe a much lower amount on your loan, a higher interest rate will still be affordable.

The ability to take the risk depends on your financial situation

Another strategy is to combine a lower interest rate loan with a more aggressive repayment of your principal balance. In this way, you reduce the overall amount of your loan.

“Nobody’s 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 ARMs are often a good strategy for people who expect a big boost in income. For example, a resident doctor whose salary will double or triple in 5 years after starting to work as a full-fledged doctor. “They expect to earn more in the future, so it fits more with that life path.”

Anyone considering an adjustable rate loan should fully understand how these loans work and read the fine print of the 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 large income or significant savings.

“Maybe they need to rethink things and just buy a cheaper house,” Lewis says. He says soaring mortgage rates this year are making many buyers feel desperate. “When you’re desperate, it’s a really good idea to step back and think about what you’re doing.”

Katrina Wooten in Florida doesn’t want to end up with a mortgage she can’t afford.

“I grew up in poverty and was the first in my family to go to college and get a degree,” she says. “I have absolutely no family to turn to if it all falls apart, so it’s up to me and it has to work out.”

Wooten therefore turns away from an adjustable loan. She is waiting to fix a rate with her lender because the house is about to be 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. not later.

She hopes that rates will fall before too long to be able to refinance. “I’m just holding out hope,” she says.