Adjustable-rate mortgages tarnished their reputation after the 2008 financial crisis, disappearing and hiding on the fringes of the mortgage market for years. But as homebuyers today grapple with skyrocketing prices and interest rates, ARMs are making a comeback.
And that’s not bad at all.
ARMs are attractive because they start at lower interest rates than their fixed income counterparts. For some borrowers, ARMs make it possible to buy a home even when fixed-rate mortgages have passed the affordability point.
MRAs are okay for some buyers and too risky for others, and the line between these judgments can be blurred. It’s important to understand what’s really behind this year’s surge and how to decide if an adjustable rate is right for you.
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MRAs are on the rise
Adjustable rate mortgages accounted for 3.1% of home loan applications in early January, according to the Mortgage Bankers Association. Four months later, ARMs accounted for 10.8% of mortgage applications. Why has demand for ARM more than tripled in just four months? Because interest rates on fixed-rate mortgages have skyrocketed:
In Freddie Mac’s weekly interest rate survey, the 30-year fixed-rate mortgage averaged 3.22% in the first week of 2022, rising to 5.3% in mid-May.
While the 30-year fixed rate rose more than 2 percentage points, the average interest rate on the 5-year ARM rose less than 1.6 percentage points: from 2.41% to 3.98%.
Rising mortgage rates have eroded homebuyers’ ability to borrow. If you can afford $1,500 a month in principal and interest, you can borrow $344,700 on a 30-year, 3.25% fixed-rate mortgage. But at 5.25%, you can afford to borrow about $271,600, or $73,100 less.
Some homebuyers did not revise their price ranges lower as interest rates rose. After months of house-hunting, they got accepted offers, only to find they couldn’t afford the monthly payments on 30-year fixed-rate mortgages. They turned to cheaper ARMs to salvage their home purchases.
“Borrowers are turning to ARMs for lower mortgage rates to try and keep monthly payments the same even as interest rates rise,” said Odeta Kushi, deputy chief economist at First American Financial, in a statement on the latest episode of the REconomy podcast company .
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How MRAs work, in a nutshell
Adjustable rate mortgages taken out today have an introductory interest rate set by the lender that lasts a number of years—usually five, seven, or 10. After the introductory period is over, interest rates go up or down depending on a third interest rate. which the lender does not control. Most ARMs subscribed in 2022 will be indexed to the SOFR (Secured Overnight Financing Rate) during the adjustment period, with the rate changing every six months.
ARMs pass the risk on to the borrower – monthly payments go up as interest rates rise. However, thanks to regulations enacted after the financial crisis, ARM payments are less likely to reach prohibitive levels than they were in the first decade of this century.
For example, when you apply for a loan, “you’re being evaluated based on your ability to repay over the lifecycle of the ARM,” not just the introductory rate, Robert Heck, vice president of mortality, told Online Mortgage. mediation, in an email.
Who are MRAs suitable for?
This year’s ARMs are real. They’re safer and have fewer pitfalls than the unhealthy fitting devices that were popular during the housing boom before the 2008 crash. But ARMs aren’t for everyone. They shift the risk from the big fish to the small fish: With a fixed-rate mortgage, rising interest rates are the bank’s problem; When you get an ARM, rising interest rates become your problem. MRAs can be worth the risk for buyers who:
Plan to sell the house within a few years.
Expect a significant increase in household income.
The first group may include people who want to buy their first home while they can still afford it and move to a nicer place in a few years, preferably before the ARM’s fixed-rate period ends.
Kushi explained on the podcast that the reasoning goes like this: “If you’re a first-time buyer and you’re probably moving out of your first home in the next three to seven years, there’s not a lot of benefit in paying the premium on the fixed-rate mortgage for all those extra years.” , which are unlikely to be used.
The second group includes shoppers, such as residents, who expect to earn more money once their stay is over. These may be families where a spouse is about to earn an advanced degree or certification that will result in a higher salary. This could even include homebuyers who are on track to pay off their student loans within a few years, freeing up income that could be spent on house payments.
Also read: How do higher mortgage rates help reduce inflation? Here’s an explanation.
For whom MRAs are not suitable
The above two categories don’t mention the scenario at the top of this article: buyers receiving ARMs because they can’t afford the monthly payments on a fixed-rate loan. If you can’t afford a house with a fixed-rate mortgage, you might be better off buying a house at a lower price.
I’m not mad at people who were caught off guard by rising mortgage rates this spring and then stuck with an ARM to close the deal. But most of us will stick with fixed-rate mortgages, which are appropriate for buyers who expect to live in their home for a decade or more. This is especially true for people who would rather not have to worry about what happens to mortgage interest rates.
“I remember when I bought my house I was laying in bed and sleeping soundly because I had a 30-year fixed-rate mortgage, and that wasn’t going to change,” says Richard Pisnoy, director of Silver Fin Capital, a mortgage brokerage firm headquartered in Great Neck, New York.
On the other hand, he jokes that if he got a 7-year ARM, “I’d sleep soundly for a year.”
And not so solid over the next six.
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Holden Lewis writes for NerdWallet. Email: email@example.com. Twitter: @HoldenL.