Back in 2021, when mortgage interest rates hit record lows, getting an ARM (pronounced “arm”) was pretty much unheard of. Why take a gamble when you could lock in a rock-bottom rate for the next 30 years? But since then, ARMs have made a big comeback: They made up 9.5% of all mortgage applications the week ending Aug. 26, almost six times as many as in January 2021 according to data from the Mortgage Bankers Association (MBA). ARMs are one way to improve affordability in a market that’s increasingly difficult for first-time homebuyers to break into. Soaring home prices and rising interest rates have combined to inflate typical monthly mortgage payments at a rapid pace. The median payment on a newly bought home in July was $1,892, up $531 from one year prior, not counting insurance or taxes, according to the MBA. Not to mention, inflation has taken a bite out of homebuyers’ budgets. Since ARMs have lower interest rates than fixed-rate mortgages—at least to start with—they offer a way for some buyers to put those monthly payments within financial reach. “It isn’t for every homebuyer but it is a great option to help reduce that monthly cost with a lower interest rate and save money for reserves or allow more buying power in that inflated housing market.” said Suzanne Ross, a mortgage lending industry veteran and current director of mortgage product at Ocrolus, a document scanning technology firm.
Why There’s an ARMs Race
An adjustable-rate mortgage is just what it sounds like—a home loan where the interest rate adjusts after a certain amount of time—and monthly payments along with it. Typically, the rate moves in tandem with a predetermined outside benchmark such as the SOFR—the rate at which banks are lending money to one another. The rate can move up or down. The rate offered for the loan will usually be a set amount above the SOFR or whatever other rate the ARM is indexed to. This rate is called the margin. For example, if the margin on a loan is 3% and it’s indexed to the SOFR, which is at 4%, the rate on the loan will be 7%. The rate is usually fixed for a certain number of years and then is adjusted every so often. For example, in a 5/1 ARM, a common type of adjustable-rate home loan, the rate is fixed for five years and adjusted every one year after. (The first number tells you the fixed-rate period, and the second number tells you how often it’s adjusted.) Borrowers will usually start off with a lower rate for an ARM than they would with a fixed-rate loan. On Sept. 1, the average rate for a 30-year fixed rate conventional mortgage was 5.66%, according to Freddie Mac. For a median-priced home, which sold for $403,800 in July, according to the National Association of Realtors, you’d be looking at a monthly mortgage payment of $1,867, assuming a 20% down payment. But the average rate on a 5/1 ARM was more than one percentage point lower, at 4.51%. That would save about $228 a month for the first five years on the same mortgage for a total of $13,680 over that time. As of July, buyers could afford $44,000 more house with an ARM than with a fixed-rate loan, all other things being equal, according to an analysis by Mark Fleming, chief economist at First American, a title insurance company. “Given the lower mortgage rate that is typically offered on an ARM today, compared with the 30-year, fixed-rate mortgage, ARMs offer prospective first-time homebuyers an option to recapture some house-buying power in a rising rate environment,” Fleming wrote in his July analysis. That’s for buyers who are willing to accept the risk of a higher monthly payment down the road if interest rates rise—something you don’t have to worry about with a fixed rate.
So What’s the Catch?
No one is sure where they’ll be in the next few years, so it’s possible an ARM could prove costlier than a conventional loan in the long run. For instance, mortgage giant Fannie Mae predicts that by 2023, the average rate offered for a 30-year fixed rate mortgage will drop to 4.50% from its 5.20% average in the second quarter of 2022, but Fannie Mae doesn’t venture to guess what it will be farther out. To get an idea of how quickly mortgage rates can go up and down, just look at the last few years. Mortgage rates usually move in the same direction as yields on 10-year Treasurys, which tend to rise in response to investor concerns about inflation, among other factors. And those yields and mortgage rates have been on a roller coaster ride since the pandemic hit. Going into 2020, the average rate for a 30-year mortgage was 3.72%, and had been hovering between 3% and 5% for most of the previous decade, as measured by Freddie Mac. When the pandemic hit, mortgage rates began a long slide, bottoming out at a record-low of 2.65% in January 2021. The slump in mortgage rates was largely due to the Federal Reserve, which lowered its benchmark interest rate to next to nothing, making money cheaper for banks to borrow in an effort to keep financial markets and the economy afloat through the worst of COVID-19. This March, when the central bank began withdrawing that monetary support and hiking its interest rate to combat inflation, mortgage rates shot right back up again to multi-decade highs, peaking at 5.89% in June. They’ve been up and down since then, and no one is sure where they’ll go next. Rates have risen in recent weeks after Federal Reserve officials said they were determined to raise rates more to bring inflation under control. “The risk is definitely the ambiguity around it,” said Kevin Parker, vice president of field mortgage originations at Navy Federal Credit Union. ARMs may be a better fit for people who aren’t planning on staying in their homes for very long, Parker said. Professionals who get paid in large lump sums at unpredictable times—such as real estate agents and entrepreneurs—also like ARMs because they can have low monthly payments during fallow periods, and pay down their mortgage when their ship comes in, Parker said.In other words, whether an ARM is a good idea depends on your circumstances.
But Wait a Second, Didn’t ARMs Cause the Housing Crash?
All this talk of ARMs may bring back bad memories for anyone who was around during the financial crisis of 2007-2008. Mass borrower defaults on subprime loans—most of which were ARMs—contributed to the collapse of the housing market, which sent shockwaves through the economy and ultimately caused the Great Recession.Today’s ARMs are a different breed, Ross said. Not only were ARMs more popular back then, making up around 30% of new mortgage applications, according to the MBA, but they often included low initial rates and payments that ballooned over time, heightening the risk that borrowers would be unable to repay as time went on. Exotic mortgage products like that have become a rarity since the crisis. Financial regulations have improved since then too, and banks’ standards for mortgage lending have risen dramatically, so typical mortgage holders are in better financial shape. Have a question, comment, or story to share? You can reach Diccon at dhyatt@thebalance.com.
