Adjustable-rate mortgages got a bad rap after the housing bust.
Many homebuyers used the low initial interest rates on adjustable loans to keep payments low, but weren't able to afford to pay their mortgage when the loans reset to a much higher rate a few years later.
In the years since, banks have tightened their lending standards to ensure borrowers who get adjustable-rate loans, or ARMs, can afford a rate reset. And as interest rates have begun to rise, ARMs have become a more attractive option for homebuyers seeking the lowest rate on a home loan.
Mortgage rates have risen almost a full percentage point since hitting record lows about a year ago. At the same time, the spread in the rates between adjustable loans and fixed-rate loans has widened.
Is an adjustable-rate mortgage right for you?
Here are some things to consider when weighing whether to take on an adjustable-rate mortgage:
Length of home ownership
Banks typically offer adjustable-rate mortgages with a fixed interest for five, seven or 10 years. After that initial period, the loans could reset to a higher rate, sometimes multiple times.
That's why it can make good financial sense to use an ARM when buying a home that you plan to sell before the initial fixed-rate period ends, say in less than five years. In that scenario, you'd pay a lower interest rate that if you had a 30-year, fixed loan and then sold the home within five years.
"If the homebuyer plans on staying in the home for a period longer than the initial rate lock, consider a fixed-rate loan, particularly while we're still enjoying historically low mortgage rates," says Don Grant, a certified financial planner in Wichita, Kansas.
Banks typically don't hold on to loans until they're paid off by borrowers. They sell them to investors or, in many cases, government-owned mortgage buyers like Fannie Mae and Freddie Mac. But to do this they must follow the government's lending standards when they qualify a borrower for a loan.
Those lending standards were tightened as home loan defaults skyrocketed after the housing crash. That's made it tougher to qualify for a home loan, but particularly an adjustable-rate mortgage, says Rick Sharga, executive vice president at home auction site Auction.com.
A key factor that lenders consider when evaluating credit worthiness is the borrower's debt-to-income ratio, or how much of their income goes to cover debt payments.
Expect that anything above 43 percent debt will rule out most borrowers, although the lender may take into account the borrower's prospects for earning more money or paying down existing debt after a few years.
ARMs can offer a lower monthly payment than fixed-rate loans. That means you can put that extra money to pay down other debt or use it to invest, for example.
The typically lower interest in an ARM also means more of the monthly payment goes toward principal, accelerating the homebuyer's equity in the home, notes Grant.
But if you're more comfortable with the security that your payments won't go up, stick with a fixed-rate loan.
"The ability to lock in the biggest component of your household budget and know that it's not going to increase in years to come is a key step toward being able to increase your lifestyle and savings in the years ahead," says Greg McBride, chief financial analyst at Bankrate.com.