The average adjustable rate mortgage (ARM) rate on a 5/1 ARM averaged 4.01% in December 2018. This is up half a percentage point from a year earlier when the rate was 3.53%.

ARM rates have increased significantly over the past year, largely due to the Federal Reserve’s (the Fed’s) decision to increase the target Federal Funds rate. Expect ARM rates to continue to rise in tandem with the Federal Funds rate in 2019 and the years to come.

Higher ARM rates will discourage ARM over-use, a good thing for the stability of the housing market. However, higher fixed rate mortgage (FRM) rates make ARMs more alluring to buyers. As higher FRM rates continue to reduce purchasing power in 2019, expect to see more buyers turn to ARMs to make up the gap. For a certain segment of homebuyers, ARMs will save money and increase their purchasing power in 2019. However, long-term homebuyers may still prefer the security of an FRM rate. It is up to real estate professionals to guide homebuyers to the right mortgage product for their situation and investment experience.

Updated January 18, 2019. Original copy released April 2016.

Chart update 01/18/19

Dec 2018 Nov 2018 Dec 2017
Average 5/1 ARM rate 4.01% 4.21% 3.53%

The chart above shows the average interest rate for the first five years after origination on a 5/1 ARM, the most popular type of ARM for homebuyers. After the initial five-year period, the ARM rate is adjusted annually based on an index figure.

ARM rates yesterday, today

The adjustable rate mortgage (ARM) rate was legalized in 1980 through passage of the Depository Institutions Deregulation and Monetary Control Act of 1980.

Unlike a fixed rate mortgage (FRM), which guarantees a set rate over the life of the mortgage, ARMs shift inflationary and economic risk from the mortgage holder to the borrower by allowing mortgage rates to “float” with the market.

The rate is tied to a specified index that varies based on market factors. The initial interest rate before adjustments is called the teaser rate. On adjustment, the new ARM rate equals the yield on the index specified in the ARM note plus the lender’s profit margin. Common indices used to periodically adjust the ARM rate include the:

One of the interest rates with the most influence on ARM rates is the Federal Funds rate, which is the target short-term borrowing rate the Federal Reserve (the Fed) sets for banks to lend to each other. From 2009 through December 2015, the Fed’s target rate was 0% – 0.25%, essentially zero. Then, at the end of 2015, the Fed increased the target rate to 0.25% – 0.5% to prepare for an expanding economy.

Likewise, from December 2015 to January 2016, the average ARM rate increased the most in a single month since 2013, jumping 0.3 percentage points. It fell back for most of 2016 before rising again at the end of 2016 and again, more significantly, at the end of 2017. The Fed is expected to continue its rate rise throughout 2018, which will result in higher ARM rates.

ARM use: a danger for the housing market

The average ARM rate peaked in 2006 at just over 6%. At that time, three out of every four mortgages originated in California were ARMs. This proved disastrous for then-homebuyers.

ARMs are far riskier mortgage products than FRMs. When ARM rates reset, the higher payment often results in payment shock, leaving many homeowners simply unable to pay.

Many ARM users plan to refinance into an FRM before their ARM resets, but high unemployment rates made this impossible for many homeowners during the recession. This situation is partly to blame for the 2008-2009 foreclosure crisis.

The epic catastrophe caused by ARMs helped steer homebuyers away from the mortgage product in the years following the recession. Stricter underwriting standards, which granted the mortgage with the reset rate in mind rather than the teaser rate, also helped keep ARM use in check. Still, ARM use inched up when the average ARM rate was at its bottom in 2013. By 2014, roughly out of every six mortgage originations was an ARM, according to Freddie Mac. Historically, this ratio is considered about average for a healthy market.

ARM use has since cooled slightly, due to less demand since FRMs — less risky and easier to qualify for — have seen lower, desirable rates in 2015-2016.

The future of the ARM

What will the ARM chart above look like in the coming months and years?

Aside from short-term action, the ARM rate will only rise over the next several years. This is because the Federal Funds rate — which influences the indices to which most ARMs are tied — was at its bottom in 2015 and now can only rise. The average ARM rate also follows the historical 60-year rate cycle, which reached its bottom in 2012. Now, we expect rates to rise over the next three decades before falling each year, as in the 1980s through 2012.

As interest rates on FRMs continue their upward trend in 2018, overextended homebuyers may turn in increasing numbers to the lower rates offered by ARMs.

However, don’t expect ARM use to swell to Millennium Boom size anytime soon. Homebuyers won’t soon forget the havoc created by ARM over-use. This is true especially for today’s savvier first-time homebuyers, who came of age during the tumultuous foreclosure crisis and watched their parents’ generation succumb to the perils of ARM use.