There has been a dramatic transformation in the housing market over the last few years, particularly regarding mortgage rates. In 2020 and 2021, prospective homebuyers enjoyed historically low interest rates, with rates on mortgage loans hovering around 3%. This favorable environment made homeownership more accessible and affordable for many Americans. 

However, as inflation ticked up, the landscape changed rapidly. With the Federal Reserve implementing aggressive measures to combat inflation, rates across all borrowing types increased quickly. In turn, mortgage rates soared, even surpassing 8% in late 2023, which significantly increased the cost of homeownership. And, the Fed has kept its benchmark rate paused at a 23-year high over the last several months, so borrowing costs have remained high overall. 

But recent economic indicators suggest that there could be a shift in this trend soon. Over the last couple of weeks, the average mortgage loan rate has dropped below 7% on the heels of cooling inflation. In turn, this may be an opportune moment to enter the market. But if you're thinking about buying a home now, it's important to carefully consider whether an adjustable-rate mortgage (ARM) loan makes sense in today's economic climate.

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Why an ARM loan could make sense with mortgage rates cooling

While an ARM loan won't make sense for everyone, this type of mortgage loan offers a few potential advantages in the current market conditions. For starters, ARMs could provide an attractive entry point for homebuyers. That's because these loans typically start with lower interest rates compared to the rates on fixed-rate mortgages, which can translate to lower initial monthly payments. This feature can be particularly appealing for buyers who are stretching their budgets to enter the housing market.

But the low entry point isn't the only draw. If the cooling trend in mortgage rates continues, borrowers could also benefit from potential rate decreases on ARM loans in the future. After all, unlike fixed-rate mortgages, ARMs adjust periodically based on market conditions. So, if rates continue to fall, ARM holders may see their interest rates and monthly payments decrease accordingly. That could result in potentially saving thousands of dollars over the life of the loan.

Taking advantage of what an ARM loan offers in today's climate could also be advantageous if you're not planning to stay in the home long-term. If you anticipate selling or refinancing within a few years, you could take advantage of the lower initial rates without facing the risk of rate increases in the later years of the loan.

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Why an ARM loan may not make sense with mortgage rates cooling

Despite the potential benefits, ARM loans also carry inherent risks. While rates are cooling, there's no guarantee this trend will continue. There are still questions about what could happen with inflation and the economy in the near future, and if inflation ticks back up and the Fed hikes rates as a result, it could lead to significantly higher monthly payments on your ARM loan.

On the other hand, fixed-rate mortgage loans, while potentially starting at a higher rate, offer stability and predictability. With a fixed-rate loan, you are protected from future rate increases, providing peace of mind and easier long-term financial planning. This security can be particularly valuable in an uncertain economic environment.

And, the current spread between fixed and adjustable-rate loans may not be significant enough to justify the risk. Historically, ARMs have been most attractive when there was a substantial difference between fixed and adjustable rates. 

But right now, the average 5/1 ARM loan comes with a rate of about 6.52% (as of July 15, 2024) while the average 30-year fixed-rate mortgage loan comes with a rate of 6.97%. Overall, the rate gap between the two mortgage loan types is narrow, which means that the potential savings may not outweigh the risk of future rate adjustments.

How to decide whether an ARM loan makes sense for you

Determining whether an ARM is the right choice depends on your circumstances and financial goals. That said, there are some factors to consider to help you decide:

• Length of homeownership: If you plan to stay in the home for a short period, an ARM might be beneficial. However, if you're seeking a long-term residence, a fixed-rate mortgage could provide more stability.
• Financial flexibility: Consider your ability to handle potential payment increases. If your income is likely to grow or you have significant savings, you may be better positioned to manage the risks of an ARM.
• Risk tolerance: Assess your comfort level with uncertainty. If the possibility of rising payments causes significant stress, a fixed-rate mortgage might be the better option.
• Market outlook: While it's impossible to predict future rates accurately, consider expert forecasts and economic indicators to gauge potential rate trends.
• Refinancing potential: Consider whether you'd have the option to refinance to a fixed-rate mortgage in the future if rates become less favorable.

The bottom line

As mortgage rates show signs of cooling, the decision between an ARM and a fixed-rate mortgage becomes more nuanced, so it's important to carefully weigh your options. ARMs offer the potential for lower initial payments and possible savings if rates continue to decline. However, they also carry the risk of payment increases in an uncertain economic environment. 

Ultimately, the choice between an ARM and a fixed-rate mortgage should be based on a careful analysis of your financial situation, future plans and risk tolerance. By considering these factors and staying informed about market trends, you can make an informed decision that aligns with your homeownership goals and financial well-being.