Adjustable-rate mortgage calculator: Estimate how higher rates can affect your payment

With 30-year fixed mortgage rates holding above 7% for weeks, more homebuyers are considering adjustable-rate mortgages in search of smaller monthly payments.

The appeal is straightforward. ARMs usually start with lower interest rates than standard 30-year fixed loans, at least at first. Recently, that gap has been sizable. In late October, the average rate on a 5-year ARM that resets annually afterward was 6.41%, almost a full percentage point below the 7.37% average for a 30-year fixed mortgage, according to the Mortgage Bankers Association. For many borrowers, that difference can mean hundreds of dollars in monthly savings during the initial fixed period.

That also helps explain why ARMs rose from 8% of mortgage applications in early September to 11.3% in late October, according to MBA data.

Still, the lower starting rate comes with risk. Unlike a conventional fixed-rate mortgage, an ARM generally locks in its initial rate for only a limited time, often five, seven or 10 years. After that, the rate can change periodically with movements in a benchmark interest rate, which could push the monthly payment higher.

Some borrowers are betting that mortgage rates will drop enough for them to refinance into a fixed-rate loan before the ARM resets. In that case, they could benefit from lower payments now and secure a favorable fixed rate later.

But if rates move higher instead, borrowers may face monthly payments that are much harder to manage.

“Refinancing should be treated as an upside scenario, not an exit strategy, because neither lower rates nor loan approval at that future date is guaranteed,” says Michael Young, director of home lending at Wealthfront.

That is why experts advise stress-testing an ARM before committing, so you know whether you could still handle the payment if rates climb.

Stress-test your adjustable-rate mortgage offer before you sign

Begin by comparing the monthly payment on an ARM with the cost of a traditional 30-year fixed mortgage.

For instance, a $400,000 mortgage at a 30-year fixed rate of 7.37% would run about $2,761 per month in principal and interest.

At an ARM rate of 6.41%, the payment would drop to about $2,505, a savings of roughly $256 a month, or about $15,400 over the first five years.

Those savings, however, do not necessarily last. Once the introductory period ends, an ARM’s interest rate can increase within limits set by rate caps.

For example, a five-year ARM starting at 6.41% could climb to 8.41% in year six and 9.41% in year seven under typical rate-cap rules. If it stayed at 9.41% through year 10, the borrower would end up paying roughly $10,250 more over the first decade than someone who chose the 30-year fixed loan, even after the early savings are included.

And even if mortgage rates decline, refinancing is not automatic. Borrowers still need to qualify for a new loan, and changes in income, employment or home equity can make that more difficult.

The calculator below shows how rising rates can affect mortgage costs and whether refinancing into a fixed-rate loan would actually save money. It also shows that even when rates fall, refinancing is not always a sure thing, since closing costs can reduce or erase the benefit of a lower rate.

For example, refinancing from a 6.41% ARM into a 6% fixed-rate mortgage after five years could cost about $2,000 more than simply keeping the ARM, based on the calculator’s assumptions.

Even so, many borrowers may decide that added cost is worth the comfort of knowing the rate will not rise later. In the end, the best refinance choice depends on how much rates fall, what closing costs are involved and how much risk you are willing to take, says Nick Panize, president of Westgate Capital Ventures, a commercial mortgage lender and brokerage.

“If the client is saving meaningful money for the first five to seven years and can comfortably handle the loan if rates are higher when it adjusts, then you have a pretty good argument for taking the ARM,” he says. “If rates fall and you refinance, that’s just an added benefit.”