Home buyers had been enjoying mortgage interest rates as low as 2.65% the last few years but the sudden upheaval in economic conditions has changed all that and rates are now around 5%, their highest level in more than a decade.
This is leading many aspiring home buyers to look at adjustable-rate mortgages (ARMs). ARMs come and go in popularity. They've been on the sidelines until recently but applications for them have doubled over the last three months, the Mortgage Bankers Association reports.
During times when interest rates are low, most homebuyers opt for a fixed-rate loan, sometimes paying extra points to shave the interest rate. This raises the upfront cost but can save money over time, depending on where the economy goes.
ARMs, on the other hand, are generally a little cheaper to get into and may offer lower payments for at least the first few years. But it's wise to remember that the reason they're called "adjustable" is that they can go up and down with inflation, usually on an annual basis.
Currently, ARMs are going for 3.5% or so, while fixed-rate loans are edging over 5%. If the economy gets back on track and interest rates go down, consumers who have a 5% loan may feel some buyers' remorse. ARM borrowers, on the other hand, will enjoy a year or two of lower rates but may soon find themselves at 5% or more as well if inflation continues to roar along.
The biggest problem with an ARM is that it is basically a gamble. And in gambling, the house always wins, right? If interest rates go up, so does your payment. This makes it hard to budget. During the Great Recession of 2008, it meant that many consumers lost their homes because they couldn't keep up with the ever-rising payments.
Will that happen again? No one knows but it's possible.
Discount points can help
One way to try to get ahead of the game is to go for a fixed-rate mortgage while using discount points to reduce the interest rate.
Don't know the term? Discount points are, very simply, money you pay upfront to cut your interest rate over the life of the mortgage. This could be a better option than an ARM but to be sure, you need to do the math. Here's an example from Bankrate that shows how discount points could reduce costs on a 30-year, fixed-rate $200,000 mortgage.
In this example, the borrower bought two discount points. Each cost 1% of the loan, for a total of $4,000 upfront. This lowered the monthly payment from $954 to $898. If the happy new homeowners stayed in the home for 30 years, they saved $20,680.
Was it worth it? It depends on what they would have done with that $4,000 otherwise but one thing that didn't happen is that their monthly interest payment didn't go up, as it could have with with an ARM.
If you're mortgage shopping, it's worth spending some time building various scenarios. Mortgage brokers can help and so can sites like Bankrate, which has a wide variety of interactive worksheets to help you think through the many options.