Do Adjustable Rate Mortgages Make Sense Today?
Adjustable rate mortgages are mortgages where the interest rate changes during the life of the loan. The most popular structure consists of a short period where the rate is fixed and attractively low−sometimes much as a full percentage point below comparable fixed-rate mortgages. At a date in the future − usually five to ten years − the interest rate resets. Often rates are linked to an index, like the prime rate, or the S&P 500, and after the reset, rates are usually significantly higher.
Adjustable-rate mortgages, or ARMs, were popular during the housing boom twelve years ago. Lenders created a variety of ARM structures to meet the demands of a buying public that had come to believe home values would never drop. Thousands of buyers chose ARMs to take advantage of the initial attractive rate. Before their loans reset, they planned either to sell their house or to refinance to a fixed-rate mortgage.
ARMs and the Housing Crash
Twelve years ago, few borrowers thought housing values would suddenly crash, losing 30 percent or more of their value in a few months. That’s what happened in 2007, and thousands of ARM borrowers were in trouble. As their properties lost value, they could not refinance or sell. Many defaulted when they could not make their monthly payments.
ARMs virtually vanished from the marketplace after the housing crash. Though they suffered a black eye for their role in the millions of foreclosures that flooded the nation, the primary reason they disappeared after the Great Recession was the low-interest rates. With rates at 3 percent or lower, there was no market for ARMs.
Today’s ARMS are Safer
With the housing recovery well underway and rates are rising, ARMs are making a comeback. As of January 2018, about 5 percent all new mortgages were adjustable rate mortgages. As rates on fixed-rate mortgages rise to increase in the coming months, as forecasted, ARMs will likely become more popular.
Today’s ARMs are not as risky as those sold during the housing boom. At that time nearly two out of every three ARMs were “low doc” or “no doc.” Lenders did not require complete documentation of borrowers’ income, debts, and assets. Those were the days of “pulse loans” −if you had a pulse you could get a mortgage!
Upgrading the quality of and reducing the risk of ARMs is one of the lessons learned by lenders. Today’s adjustable rate mortgages are higher quality, ARM buyers are more qualified than those of a decade ago, and homebuyers who choose them are more educated and more responsible than buyers during the housing boom. In fact, in some ways, today’s ARM borrowers are better qualified than those with fixed-rate mortgages.
Some 29 percent of borrowers who qualified for ARMs twelve years ago had FICO scores below 640. Today, almost all conventional loans, including both adjustable rate and fixed rate mortgages require complete documentation and are made to borrowers with credit scores above 640. As of Q1 2017, the average credit score of borrowers with ARMs was 765 compared with 753 for borrowers with fixed-rate mortgages. Today’s ARM borrowers also have a better debt-to-income level than the average DTI for fixed-rate borrowers.
Is an ARM Right for You?
If used properly, ARMs are good alternatives for owners who need a low rate to buy the house they want and are confident they will more or sell before their mortgage resets.
If you plan to stay in your house a long time or if you want to build equity in your home as soon as possible, then an ARM is not a good idea. On the other hand, if below are some points to ponder when thinking about an ARM.
Reasons to consider an ARM
- If you expect to move before an ARM resets, you might be better off with an ARM than a fixed-rate mortgage.
- Graduates with student loan debt and or buyers having difficulty qualifying for a fixed-rate mortgage might do better with an ARM because the introductory rate may lower your debt-to-income ratio enough to qualify.
- First-time buyers in high-priced markets may find an ARM will make a starter home more affordable. By the time the loan resets, you expect to be looking for a larger home.
- ARM’s can be a good fit for young professionals entering careers that pay well, or anyone expecting a higher income in the next few years. The low-interest rate helps you get into a starter home. As your income grows, you would be making enough to handle the higher rate after the loan resets or you could refinance into a fixed rate mortgage.
- You would like to invest the amount you save in an investment that yields more than the appreciation of your home.
Reasons not to take out an ARM
- Interest rates are low, and there is little or no difference in the monthly payments on an ARM versus a fixed-rate loan;
- You would like to build equity that will protect you from a real estate downturn and be a form of automatic savings;
- The ARM you are considering could put you into negative amortization situation that will increase the amount you owe on a mortgage. You can enter negative equity if the monthly payments are not large enough to cover the cost of interest.
- The lender will charge additional fees if you refinance before the loan resets.