Once a fixture of the mortgage industry, adjustable-rate loans largely faded from the financial landscape in 2008 after playing a major role in triggering the collapse of the housing market, when home values dropped suddenly, leaving millions with mortgages they couldn’t afford.
But in recent months, rapidly rising mortgage rates and record-high home prices have fueled a comeback of adjustable-rate mortgages, along with concerns that some homeowners may be signing on for more risk than they can handle.
“ARMs are definitely becoming more and more popular,” said Trey Reed, a loan officer for Intercoastal Mortgage in Fairfax, Virginia. “In the last 90 days, we’re seeing probably a quarter to a third of all loans are ARMs. They’re an option that’s getting considered more than half the time.”
Recent data from the Mortgage Bankers Association shows that such loans now make up almost 10 percent of mortgage applications, compared to just 3 percent at the beginning of the year.
“As rates have moved higher, ARM loans have gotten more attractive to borrowers because it gives them a lower monthly payment,” said Joel Kan, associate vice president of economic and industry forecasting at the Mortgage Bankers Association. “Borrowers are certainly looking to gain any kind of advantage they can.”
Adjustable-rate mortgages offer introductory rates below rates for conventional mortgages, that typically adjust after five to 10 years, at intervals of one to two years. As of Friday, the interest rate for an 5/1 adjustable-rate mortgage, for instance, was 4.68 percent for the first five years, with annual adjustments, compared to 5.64 percent for a conventional 30-year loan.
For homebuyers like Dimitri Sakellarides and his wife, who closed on a townhouse in Alexandria, Virginia, in March, a lower monthly payment for the first several years was worth the risk of higher payments in the future.
The couple had been outbid on the first house they tried to buy and didn’t want to risk losing out again. So when they put in an offer on the townhouse, they bumped it to $30,000 above the asking price, even though the payments might strain their budget.
“We wanted this place, so we went for it,” Sakellarides said. At the time, mortgage rates had barely started to climb. The rate for a 30-year fixed was 3.75 percent. But they opted for an adjustable-rate mortgage with a 10-year initial period at 2.89 percent interest, which they estimated would make their monthly payment $200 to $300 less than it would have been for the 30-year fixed. .
Like most adjustable-rate mortgages, the loan has a cap — 5 percent, in their case, for the duration of the loan. ”So at worst, it would go up to 7.89 percent,” Sakellarides said. He added that he and his wife planned to make extra principal payments, which would help lower the monthly payments even if their rate rose significantly. “I would assume the payment wouldn’t go up much — a couple hundred more dollars a month,” he said.
But for the uninitiated, making accurate assumptions about an adjustable-rate mortgage can be difficult, as calculations can be a complicated mix of indexes, margins, discounts, rate caps and payment options.
This concerns Sarah Bolling Mancini, a staff attorney with the nonprofit National Consumer Law Center, particularly when it comes to first-time buyers, who are facing high barriers to home ownership.
“It’s just hard for first-time homebuyers to get in the door right now,” she said, adding that an adjustable-rate loan is “just sort of inherently less predictable than a fixed-rate loan.”
Mancini worries that a lack of experience might lead first-time mortgage borrowers to underestimate or misunderstand just how much their payments could increase over time.
But along with other consumer advocates, she acknowledges that reforms put in place since the housing crash have helped reduce the risks of adjustable-rate loans by requiring lenders to verify a borrower’s repayment ability. The most risky and predatory adjustable-rate mortgages — such as loans with below-market “teaser rates” that were designed to rise sharply, have also been eliminated.
Also gone are so-called “option” loans, in which monthly payments covered only interest, and sometimes not even that, meaning even though homeowners were making payments, the total amount they owed was actually growing larger.
Even worse, those loans often had initial rate windows as short as one year and could have artificially low “teaser rates” that would spike when the initial fixed period ended. Borrowers were often led to assume that home prices would continue rising, which would let them tap into the equity they had accrued and roll over their burgeoning debt into a new loan.
“You were very dependent on the home price environment for home equity. Once the value starts to fall, they owe more than the house is worth,” Kan said.
The terms of today’s adjustable-rate loans bear little resemblance to that Wild West lending environment. They generally give borrowers five to 10 years before rates adjust for the first time. That longer time horizon gives homeowners a larger window of opportunity to build up equity, which would make it easier to refinance or sell the home without owing more on the outstanding mortgage than the property is worth. Today’s adjustable-rate mortgages also have lower limits on the number of rate adjustments that can take place, with caps on each individual adjustment, as well as for the life of the loan.
“I would say it’s a much safer environment, but obviously home values can’t always go up, and it’s a risk that needs to be considered,” Reed said. “What you want to avoid is people chasing the lowest interest rate and the lowest payment and not thinking about the future.”