Remember adjustable-rate mortgages?
Rising interest rates are again making those mortgages attractive to homebuyers because the starting rate is generally lower than the rate on traditional fixed-rate home loans. But they can be riskier.
Adjustable-rate mortgages, known as ARMs, have interest rates that can go up or down over time. The rate starts out low — typically below prevailing rates on 30-year, fixed-rate mortgages. But it can change after a set time span, say three, five or seven years, making borrowers’ monthly payments more expensive.
ARMs haven’t been much in demand in recent years because rates on predictable, fixed-rate mortgages remained low. They also earned a bad reputation in the financial crisis, when underqualified borrowers lured by the initially low interest rates were unable to keep up payments when they rose.
Laws passed after the financial crisis made ARMs “much safer and more transparent than they used to be,” said Eric Stein, senior vice president at the Center for Responsible Lending.
Lenders, for example, are required to make sure borrowers have a reasonable ability to repay the loan, and ARMs no longer have prepayment penalties, so borrowers can more easily pay off or refinance the loan if they can’t afford higher payments. Still, he said, adjustable-rate loans have inherent risks: “It’s up to the borrower to weigh them.”
But as interest rates — as well as home prices — surge this year, some borrowers are again turning to ARMs to make their house payments more affordable.
The average rate on a 30-year, fixed-rate loan now tops 5%, up from less than 3% a year ago, according to the housing finance giant Freddie Mac. At the same time, the median sales price of a previously owned home was about $391,000 in April, up almost 15% from a year earlier, the National Association of Realtors reported. (And in some parts of the country, the typical sales price is far higher.) The combination of higher prices and costlier mortgages means some buyers are feeling squeezed.
“I’m getting a lot more questions and inquiries about ARMs,” said Brian Rugg, chief credit officer at LoanDepot, an online lender. “It’s a very strong tool to use, from an affordability standpoint.”
Last year, no more than 4% of mortgage applications were for ARMs, said Michael Fratantoni, chief economist with the Mortgage Bankers Association. This year, he said, the share has risen to about 10%, driven by the rise in interest rates.
“For a borrower who wants to buy right now, they can realize significant savings” by choosing an ARM, he said. The average starting rate on ARMs with an initial fixed-rate period of five years was 4.04%, compared with 5.09% for a fixed-rate loan, as of Thursday, according to Freddie Mac. That difference represents savings of more than $200 a month on a $350,000 loan — at least to start.
“That’s real money,” Fratantoni said.
Some borrowers use the savings to pay down the principal on their loan during the initial, lower-rate period, saving money over the life of the loan, Rugg said.
“If you can afford it, I recommend putting the savings away or applying it to principal,” he said.
The catch, of course, is that the rate can rise after the fixed-rate period expires. Compared with ARMs available before the financial crisis, which offered low “teaser” rates and allowed rates to be reset quickly, today’s adjustable-rate loans are safer, mortgage experts say. They typically have a fixed-rate period of at least three years and limits on how often, and how much, the rate can rise after that — such as one change per year of no more than 2 percentage points. And the risky ARMs that let borrowers pay just the interest on the loan or choose their own payment amount are no longer widely available.
Still, borrowers may see their rates increase after the initial repayment period. So they need to plan ahead to be sure they can afford bigger payments if they can’t sell their house or refinance the loan. No one can say for sure what rates will be in five to seven years, but right now, they are rising.
“There’s not much room to go down, and there’s a lot of room to go up,” said Martin Seay, associate professor of personal financial planning at Kansas State University.
It’s wise to calculate what your payment would be if the rate rose to the loan’s cap. The Consumer Financial Protection Bureau offers a guide to adjustable-rate mortgages that can help you evaluate your loan. You can also calculate the higher payment yourself using online tools like one offered by Freddie Mac.
ARMs are more complex than traditional mortgages, with more terms to understand and potential changes to keep track of, so borrowers need to take time to truly understand the terms of the loan.
“Be aware, be educated before you jump in,” said Linda McCoy, president of the National Association of Mortgage Brokers.
Here are questions and answers about adjustable-rate mortgages:
Q: What does it mean when an ARM is advertised as a 5/1, 7/1 or 10/1?
A: The first number refers to the fixed-rate period (five, seven or 10 years). The second is the number of times the rate can change after the flat-rate period — once each year, in these examples. But loans with rates that can change every six months are also common. They are typically cited as 7/6-months, 10/6-months and so on.
Some loans allow a larger increase at the first reset — often, 5 percentage points above the starting rate — then allow increases of no more than 2 percentage points, said Sean Bloch, a mortgage broker on New York’s Long Island. Some lenders underwrite ARMs based on the borrower’s ability to make payments at the initial fixed rate plus 2 percentage points, he said.
Most ARMs also put a cap on the total increase over the life of the loan. So if the initial fixed rate is 4% and the cap is 5, the rate can’t go higher than 9% — but that still makes for a much higher monthly payment.
Q: When does an ARM make sense?
A: If you are confident that you will remain in the home for a relatively short period — less than the loan’s fixed-rate period — an ARM may make sense. You can sell the home or refinance the loan before the rate is reset. People who can realistically expect a significant increase in salary before the reset — like medical residents or law students — may also benefit, McCoy said.
But the option may be too risky for, say, hourly earners looking at an adjustable-rate loan as the only way to afford a specific home.
“I’m not going to give them an ARM,” she said. They could lose the house, and much of their investment, if they can’t make the higher payments.
Ultimately, it comes down to your comfort with risk, said Seay at Kansas State.
“I have a low risk tolerance,” he said. “I would never have an ARM.”
Q: Can the interest on an ARM be reset to a lower rate?
A: Yes. After the initial repayment period, ARM rates are based on a benchmark market index and a set rate known as a margin. So if the index falls, the rate on the loan can, too. But many loans have a floor below which the rate cannot fall. Ask your lender or review your loan disclosure documents to find out what that rate is.