Is An Adjustable-Rate Mortgage a Bad Idea?

By Realty Times Published Nov 30, 2022 11:39 am

The most popular home loan in America continues to get more expensive. Home shoppers are already dealing with the highest borrowing costs in two decades, and now the average rate for a 30-year fixed mortgage had gone beyond 7%, making it double what it was when we started 2022.

Home price increases are slowing down, but buyers are still being pushed out because of the drastically higher financing costs. The numbers aren’t working out for many buyers, and the 7% marker becomes a mental hurdle for many buyers, even if they qualify. Many buyers are trying to wait it out and see if rates will come down, despite there not being many indications they’re going to.

While some buyers are bowing out of the market altogether, others are looking at a different option, which is an adjustable-rate mortgage.

The five-year adjustable-rate mortgage rate (ARM) averaged around 5.8% in mid-October. Even though this may seem better than more than 7% rates, the ARM was averaging around 2.55% at the same time last year.

An adjustable-rate mortgage typically starts with a fixed interest rate of between three and ten years. The rates are lower than they are for a fixed-rate loan like the ever-popular 30-year mortgage.

That sounds great, but once the initial term of the loan is up, the ARM rate can adjust up or down based on a benchmark, such as the prime rate.

At the end of September, borrowers applying for an ARM were around 12% of the total share of applications. That was the largest amount since March 2008, and it’s also more than four times the level from the start of the year.

While there are buyers who feel like an ARM is a workaround they need, some are afraid of this type of loan because of the 2008 situation. There were foreclosures around the country spiraling out of control.

At the heart of the foreclosures in 2008 were ARMs. There were ARMs with tantalizing teaser rates. There were ARMs for one-to-two years, ARMs requiring no documentation, negative amortization ARMs, and so on.

Lenders were greedy at the time, selling loans to other people and eliminating their risk if something went wrong.

While 2008 was a scary time, at least partially driven by ARMs, they have helped people since the early 1990s get into homes more affordably.

In December 1994, the Fed tightened its policies when there was a rise in inflation on the horizon, and the rate on a 30-year loan went from slightly under 7% to more than 9%. That led to the share of ARM borrowers being as high as 35%.

Around ¾ of ARMs originated currently have fixed periods of five, seven, or ten years before the rate adjusts, so homeowners have more time to build equity with those longer timelines. With a more extended timeframe on an ARM, and the equity-building it facilitates, it does reduce the risk of foreclosure and borrowers have more of a chance to refinance. Most homeowners will refinance later on with a fixed loan.

Compared to the 1990s and the situations leading up to 2008, underwriting is much stricter now. Congress rewrote rules after the crisis of 2008 about who could get an ARM as part of the Dodd-Frank Act.

Experts say that they expect the application share for ARMs to keep going up, but that doesn’t necessarily indicate a problem as long as lenders maintain appropriate lending standards.

Refinance loans are down 86% from last year, and applications for purchase loans are down by 39%.