Mortgage interest rates have climbed to their highest levels in two decades, which means higher payments for less home. So an older loan known as an adjustable rate mortgage, or ARM, is making a comeback.
“If you think rates are going to settle down or even go down, then you’re going to get that benefit from the ARM,” said Lee Foster, an Orlando-based sales manager with Fairway Independent Mortgage Co.
The trend might cause concern among those who remember the integral role ARMs played in the Great Recession of 2008. But experts say safeguards put in after the housing crash make these loans less of a risk to the economy, even if they still carry risk for homebuyers.
The Federal Reserve has raised interest rates several times this year in order to combat inflation. Fixed rates for 30-year mortgages have gone from historic lows of less than 3% last November to 6.92% on Thursday, according to federal mortgage company Freddie Mac.
But while fixed-rate mortgage applications declined in September, applications for ARMs are up more than three times where they were at the start of the year, according to the Mortgage Bankers Association.
ARMs allow buyers to purchase a home at a lower rate and graduate to the full rate after a fixed period, often five years.
The average rate for a five-year ARM is 5.81%, according to Freddie Mac, giving a buyer a 1.11-percentage point break on a fixed loan for the first five years.
Then after five years, it starts to adjust yearly based on interest rates are at the time, with caps on how how much it can go either way. “It could go up or down,” Foster said.
So while the first years are at a discount, an ARM can be riskier in a market where either home values or interest rates are volatile.
“It’s something that’s much more in vogue when fixed rates are going up,” said Bob Griffiths, general manager of home services for online mortgage lender Houwzer.
Modern ARMs began in the 1980s. “Banks were not always comfortable holding a mortgage on the books for 30 years,” Griffiths said. As interest rates rose, banks didn’t want to be stuck with mortgages locked in at lower rates.
But ARMs fell out of favor after the Great Recession of 2008. Research by Yahoo Finance shows applications for ARMs dropped from a high in 2005 around 35% to almost none by 2009.
In the early 2000s, banks created a variety of ARMs that let people buy homes with no money down or even to not make full mortgage payments. Rates would also adjust much higher, or sometimes require major balloon payments.
These loans were often made to people who didn’t have the income or credit history to repay them, Foster said. Often the plan was to sell the house or refinance the loan before the period of adjustment.
But when home values plummeted in 2008, ARMs holders found themselves locked into high rates on mortgages that were hundreds of thousands of dollars more than the house was worth now.
“The lesson the regulators learned was, when people get very hot for buying houses, we have to stay disciplined on credit profiles, the amount of money put down, and appraisal standards for homes,” Griffiths said.
Mark McArdle, assistant director of mortgage markets for the Consumer Finance Protection Bureau, says ARMs are more secure because of federal standards created after the crash. The vast majority of loans are now secured by federal institutions and typically have five, seven or 10-year initial rate, instead of one or two years.
Crucially, applicants for ARMs today have to qualify for a mortgage at the higher fixed rate, which makes them less likely to default in the future. “(Lenders) are not using the ARM rate to get you into more home than you can afford,” Griffiths said. “This isn’t going to end like 2008.”
Foster said most of the ARMs he sees these days don’t go to first-time homebuyers like they did during the housing bubble. “People who are savvy and understand the market get ARMs,” he said.
McArdle said the bureau continues to track the rate of ARMs, and they are still barely 10% of all mortgages. He said if a buyers are offered an ARM they think might be predatory in some way, they should report it to the CFPB’s complaint website: consumerfinance.gov/complaint
ARMs are also a popular instrument for investors, Foster said, because they can buy a home at the lower rate and sell it before the rate adjusts. “They make sense if you know you’re not going to be in that home in a few years,” he said.
Griffiths and Foster agree that the fundamentals of the market today make it more stable than before the crash.
“The availability of credit has been extremely tightened,” Griffiths said. “If there’s a policy issue, it’s whether or not we’ve gone too far overboard and we’re shoving people out of home ownership.”
