These Mortgages Are in High Demand As Rates Climb -- But Are They a Good Idea?

There's a specific type of home loan that's gaining popularity.

From mid-2020 through the end of 2021, consumers were privy to affordable mortgage rates. That all came to a grinding halt in January, when mortgage rates proceeded to shoot upward. Over the past four months, rates have risen at an alarming rate, putting the pressure on buyers who are already grappling with limited inventory and sky-high home prices.

To cope with this turn of events, buyers are increasingly turning to adjustable-rate mortgages, or ARMs. With an ARM, you lock in an initial interest on a mortgage that's valid for a limited period of time. Once that period ends, your rate has the potential to rise -- or fall -- with market conditions.

The Mortgage Bankers Association reports that recently, the share of ARMs increased to 11% of total mortgage volume. And all told, the demand for ARMs has reached a 14-year high.

But is taking out an ARM a smart move in light of rising interest rates? Here's what you need to know.

The pros and cons of getting an ARM

When you take out an adjustable rate mortgage, there's the potential to start off with a much lower interest rate on your home loan than with a fixed-rate loan. That's the benefit. The downside, however, is that in time, your home loan could become more expensive -- to the point where you can no longer afford it.

Right now, the average 30-year mortgage rate is 5.542%. By contrast, the average 5/1 ARM rate is 4.448%. That's a difference of over 1 percentage point. And it could make for much lower monthly mortgage payments -- at least initially.

But what if market conditions lead to higher borrowing rates after five years (which is when the rate on a 5/1 ARM can start to adjust)? In that scenario, your rate could creep upward to the point where it's higher than the 5.542% you could've locked in on a fixed-rate 30-year loan. And so anytime you sign an ARM, you run the risk of facing more expensive payments down the line.

Is an ARM right for you today?

If you're buying a starter home, then you may want to consider taking out an ARM, since doing so could result in a fair amount of savings. If you don't plan to stay in your home very long, you might very well end up selling it and getting out before the interest rate on your mortgage has time to change.

But if you're buying your forever home, you'll need to consider the risks of getting an ARM. You may decide you'd rather deal with a higher mortgage rate that comes with a fixed loan, but one that's guaranteed not to climb over time.

Of course, you could always sign up for an ARM and refinance your mortgage to a fixed-rate loan if borrowing conditions are more favorable in a year or two. It's a route worth considering, but be aware that mortgage rates may not drop in the next few years. And even if they do, refinancing isn't a sure thing, and it costs money to refinance, so that's a risk you'll need to grapple with if you adopt this particular strategy.