As mortgage rates rise, ARM loans are increasing
ORANGE COUNTY, California – Buying a home these days can cost you an arm and a leg, but some choose an arm.
ARM or adjustable rate mortgage loans, once thought to be one of the factors that led to the Great Recession of 2008, are making a comeback. Realtors and mortgage brokers say the lending program is different this time.
As mortgage rates rise — and rates are expected to continue rising — realtors are seeing more homebuyers exploring and utilizing the ARM financing option instead of the traditional 30-year fixed rate option.
“The majority of my customers have used ARMs,” said Abby Ronquillo, founder of NetRealty in Corona. “It’s their way of fighting high interest rates.”
Unlike a traditional 15- or 30-year fixed-rate mortgage, an ARM is a mortgage option that allows a borrower to secure a lower interest rate (lower than a fixed rate) for a few years to adjust.
Most adjustable rate mortgage options offer five, seven, or ten years. Once the ARM rate changes, the interest rate and the borrower’s payment usually go up or down depending on the state of the economy. For example, a borrower with a 7/1 ARM would have a fixed interest rate — or a lower payment — for the first seven years before the interest rate changes.
“It’s a good option for the right person in the right situation,” said Jeff Lazerson, president of Mortgage Grader in Laguna Niguel. “It’s so important to recognize that lower interest payments can wipe out payment, especially in the jumbo market. There’s nothing wrong with that, but you have to understand that you don’t know what the interest rate will be at the end of the vesting period.”
According to the Mortgage Bankers Association, applications to use an ARM loan to buy a home in California in February 2022 were 11.1%. Applications for ARMs rose 6.2% year over year in California, the highest in the country. Nationwide, total applications for ARMs rose 6.6% week-on-week through March 25.
As of April 5, the national average for 30-year fixed-rate mortgages is 4.8%. The average 10/1 ARM rate was 3.9% according to Bankrate.
ARMs have a bad reputation as one of the reasons for the mortgage crisis and Great Recession of 2008.
In a study by the Brookings Institute, the authors blamed the rapid rise in lending to subprime borrowers (borrowers who would not normally have obtained credit) and the introduction of short-term ARM products as one of the origins of the financial crisis.
The authors said lenders handed out two- or three-year ARM products with low initial payments that borrowers can refinance from after the interest rate matures.
“These so-called ‘teaser’ interest rates were often not that low, but low enough for the mortgage to go through,” wrote Martin Neil Baily, Robert E. Litan, and Matthew S. Johnson. “Borrowers were told that in two or three years the price of their house would have risen enough for them to refinance the loan. Home prices in many places were increasing at 10% to 20% per year, so if this continued for so long, a 100% LTV would drop to about 80% after a short while, and the household could settle with a conforming or prime jumbo mortgage refinance on more favorable terms.”
The problem is that the housing bubble has burst. Mortgage payments skyrocketed as the economy faltered, and many borrowers were unable to pay or refinance their newly adjusted mortgages. This led to a wave of home foreclosures.
From 2004 to 2006, ARM accounted for around 30% of home loan purchases. The traditional fixed rate mortgage rate during that time was about 6%, Joel Kan, associate vice president of economic and industry forecasting at the Mortgage Bankers Association, said in an email to Spectrum News.
“It was also when mortgage supply was at all-time highs and underwriting was a lot looser and there were riskier ARM products,” Kan said. “After the Great Recession of 2008-10, policies were much tighter (Dodd-Frank) and underwriting standards were tighter and borrowers had stronger credit profiles.”
Kan added that “over the past 10 years, we’ve seen a shift towards ARM loans with longer fixed-rate periods, ie based on our application data.”
Sheila Nufable, a community lending officer at Bank of America Pasadena, said she doesn’t advise ARM loans for first-time homebuyers.
“Many of my clients are focused on getting a fixed interest rate over the long term,” Nufable said. “You don’t want to take that risk. They are cautious because the market is so volatile. You cannot predict how it will be in five, seven or ten years.”
According to Nufable, ARM loans are generally for investors or those who don’t plan to stay in their homes for the long term.
“They’re hoping to sell the property before the interest rate comes due,” Nufable said. “It’s a good product for investment houses or second homes. The ARMs are for riskier buyers.”
For Ronquillo, their customers with ARM loans are betting on lower payments during the introductory period and refinancing before the interest rate is due. She said qualifying for an ARM loan has become more stringent, requiring higher credit ratings, FICO scores, and healthy cash reserves. She added that the typical homeowner would refinance every four to seven years anyway.
“Many of my clients understand the bigger picture — interest rates go up and down,” Ronquillo said, adding that a client saves $1,000 each month on a 7/1 ARM loan instead of a 30-year term. “ARM loans are for the highly qualified. In the past, all you needed to do to get an ARM loan was income. That’s why people got into trouble.”
Lazerson noted that when interest rates are rising and inflation is high, whether a borrower chooses a traditional fixed-rate loan or an ARM loan, people should be conservative with their money.
“The key is to be conservative,” Lazerson said. “Don’t overwhelm yourself, especially with ARMs. If you don’t have a lot of money left over every month. When you’re stretching your budget. Do not do it. Don’t overdo it. And if you’re not being conservative, make sure you have an exit plan.”