Adjustable-rate mortgages suffered a tarnished reputation after the 2008 financial crisis. They faded away and lurked on the fringes of the mortgage market for years. But as home buyers grapple today with skyrocketing prices and interest rates, ARMs are making a comeback.
And that’s totally not a bad thing.
ARMs are appealing because they start out with lower interest rates than their fixed-rate counterparts. For some borrowers, ARMs make it possible to buy a home even after fixed-rate mortgages have risen past the point of affordability.
ARMs are appropriate for some buyers and carry too much risk for others, and the line between those judgments can be fuzzy. It’s important to understand what’s really behind this year’s surge and how to decide whether an adjustable rate would be right for you.
ARMs gain share
In early January, adjustable-rate mortgages accounted for 3.1% of home loan applications, according to the Mortgage Bankers Association. Four months later, ARMs accounted for 10.8% of mortgage applications. Why did demand for ARMs more than triple in just four months? Because fixed mortgage rates soared:
In Freddie Mac’s weekly rate survey, the 30-year fixed-rate mortgage averaged 3.22% in the first week of 2022, and shot up to 5.3% in mid-May.
While the 30-year fixed was going up more than 2 percentage points, the average rate on the 5-year ARM was rising less than 1.6 percentage points: from 2.41% to 3.98%.
Rising mortgage rates eroded home buyers’ borrowing capacity. If you can afford $1,500 a month in principal and interest, you can borrow $344,700 with a 30-year fixed-rate mortgage at 3.25%. But at 5.25%, you can afford to borrow about $271,600 — or $73,100 less.
Some home buyers didn’t revise their price ranges downward as rates climbed. After months of house-hunting, they had offers accepted, only to discover that they couldn’t afford the monthly payments using 30-year fixed-rate mortgages. They turned to lower-rate ARMs to salvage their home purchases.
“Borrowers are switching to ARMs for a lower mortgage rate to try and keep monthly payments the same, even as rates rise,” Odeta Kushi, deputy chief economist for First American Financial, said in a recent episode of the company’s REconomy Podcast.
How ARMs work, in brief
Adjustable-rate mortgages underwritten nowadays have an introductory interest rate set by the lender that lasts for a few years — commonly five, seven or 10. After the introductory period ends, rates will go up or down in line with a third-party interest rate that the lender doesn’t control. Most ARMs underwritten in 2022 will be indexed to the SOFR (Secured Overnight Financing Rate) during the adjustment period, with a rate that will change every six months.
ARMs convey risk to the borrower — monthly payments will rise if rates rise. But, courtesy of regulations enacted after the financial crisis, ARM payments are less likely to rise to unaffordable levels than they were in the first decade of this century.
For example, when applying for the loan, “you will be assessed on your ability to repay throughout the full life cycle of the ARM,” and not just on the introductory rate, said Robert Heck, VP of mortgage for Morty, an online mortgage brokerage, in an email.
Who ARMs are for
This year’s ARMs are legit. They’re safer and have fewer pitfalls than unsound adjustables that were popular during the housing boom preceding the 2008 crash. But ARMs aren’t for everyone. They shift risk from big fish to small fry: When you get a fixed-rate mortgage, rising interest rates are the bank’s problem; when you get an ARM, rising interest rates become your problem. ARMs may be worth the risk for buyers who:
Plan to sell the home within a few years.
Expect a substantial increase in household income.
The first group may include people who buy a starter home while they can still afford one, and who want to upgrade to a nicer place in a few years — preferably before the ARM’s fixed-rate period ends.
Kushi explained in the podcast that the reasoning goes like this: “If you’re a first-time buyer that will likely move out of your starter home in the next three to seven years, then there is not much benefit from paying the premium on the fixed-rate mortgage for all those extra years that one is unlikely to use.”
The second group includes buyers such as medical residents who expect to earn more money after the completion of their residency. It can include families where a spouse is about to earn a graduate degree or certification that will lead to a higher salary. It could even include home buyers who are on track to pay off their student loans within a few years, freeing up income that could be spent on house payments.
Who ARMs aren’t for
The above two categories don’t mention the scenario at the top of this article: buyers who get ARMs because they can’t afford the monthly payments on a fixed-rate loan. If you can’t afford a house on a fixed-rate mortgage, you might be better off shopping for houses at a lower price point.
I’m not mad at people who were caught off guard by rising mortgage rates this spring, then latched onto an ARM so they could close the deal. But most of us will stick with fixed-rate mortgages, which are suited for buyers who expect to live in their homes for a decade or more. That’s especially true for people who would prefer not to worry about what’s happening with mortgage rates.
“I remember when I bought my home, I would lay in my bed and sleep nice and soundly because I had a 30-year fixed-rate mortgage, and that wasn’t going to change,” says Richard Pisnoy, principal of Silver Fin Capital, a mortgage brokerage headquartered in Great Neck, New York.
On the other hand, he quips, if he had gotten a 7-year ARM, “I’d sleep soundly for a year.”
And not so soundly over the next six.