Buying a house is getting more expensive: not only are home prices rising in double digits every year, but mortgage rates are also rising and this week for the first time since May 2019 exceeded 4%. low-interest mortgages are one of the financial products responsible for the 2006 housing crisis.
The share of adjustable rate mortgages (ARM) doubled to 10% in January from a 10-year low of 4% in January 2021, according to CoreLogic data. ARMs offer an initial low rate for several years – typically 3 to 10 years – and then adjust the rate thereafter, usually annually, based on a fluctuating base rate plus an additional margin, such as 2%.
The reason for the resurgence of interest in ARM is clear: these loans offer a starting rate that is much lower than a typical 30-year mortgage. For example, the average starting rate for a 5/1-year ARM (an ARM that is fixed for 5 years and then resets every year thereafter) is 3.19%, almost one percentage point lower than the current rate of 4.16% for a 30-year mortgage, according to Freddie Mac. But, of course, once that 5-year starting rate expires, buyers can get a higher rate – like 5.19% instead of 3.19%.
This initial rate could provide significant savings for homebuyers coping with record high home prices. According to Realtor.com, average listing prices for real estate have risen nearly 27% since the start of the pandemic through February, peaking at nearly $400,000.
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Looking at the math, this means that a buyer who pays a 10% down payment on a $400,000 home and finances the balance with a 30-year loan at today’s rates would have a monthly payment of $1,752. But the initial rate of 5/1-year ARM will be $1,555—a savings of about $2,400 per year.
“When you see prices going up more and more, that purchasing power gives buyers more room to look at a home,” said Brian Rugg, chief credit officer at a lending company that provides consumer loans, including mortgages. “When you look at ARM versus fixed rates, it gives you more flexibility.”
The resurgence of interest in ARM could raise questions about whether the housing market is repeating some of the trends of 2006, when home prices rose as buyers snapped up properties and lenders opened their wallets to lend. But financial experts say there are some differences between today’s pandemic-driven housing boom and 2006, such as stricter bank lending standards.
A hike in mortgage rates is driving many buyers out of the market, the National Association of Realtors (NAR) said Thursday. About 6.3 million households have been forced out of the home buying market since the beginning of the year, according to NAR, including 2 million millennial buyers. NAR said it expects rates to rise even higher, ending the year at 4.3%.
Bad reputation
Rugg said lending standards are stricter today than they were during the 2006 housing bubble. In the run-up to housing construction more than a decade ago, some lenders issued so-called “liar loans” or mortgages that required little or no proof of income. Banks today require buyers to prove their income in order to qualify for a loan.
Adjustable-rate mortgages fell into disrepute during the housing bubble because they were offered to some buyers who could not qualify for a conventional mortgage. Because the initial “teaser” rate meant that these buyers’ monthly payments were lower, lenders were more willing to push loans, according to the Brookings Institution’s research.
However, this became problematic when the housing market collapsed and ARM moved to higher rates that these buyers could not handle.
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But today, banks are testing whether borrowers can service adjustable-rate mortgages, including whether their income can absorb the higher rate after the initial period expires, experts say. While ARM’s share is rising, it’s still much lower than it was during the housing boom of the mid-2000s, when more than half of new mortgages were adjustable-rate loans.
In addition, there are limits on how much ARM can rise, minimizing the impact on borrowers.
“The banks will make sure you qualify and there are limits on rate changes,” said Melissa Cohn, regional vice president of William Raveis Mortgage. “It’s a completely different market.”
ARMs can be useful for homebuyers who don’t plan to stay in their home for more than a few years, notes Credit Depot’s Rugg.
“This is the perfect place for people for whom this is not an eternal home,” Rugg said. “As a starter house, get a lower rate to increase income – and eventually they can trade and move to a bigger house. For me, it’s perfect.”