Americans Gambling on Rates With Most ARMs Since 2008Kathleen M. Howley and Prashant Gopal
Jung Lim plans to offset the cost of rising mortgage rates by using an adjustable-rate loan to buy a home for his expanding family. For the California endodontist, the money he’ll save makes up for the ARM’s risky reputation.
Lim, 38, whose wife is expecting a second child in December, is leaving a two-bedroom condo in Los Angeles’s Hancock Park to buy a four-bedroom house in the city’s Sherman Oaks neighborhood for $1.12 million. His lender offered him a rate for an adjustable mortgage that is about a percentage point cheaper than a fixed loan.
“If I could have gotten a 30-year fixed at the interest rate I’m getting the ARM for, I would have felt a lot more comfortable,” said Lim, who’s also a professor of endodontics at the University of California, Los Angeles. “But I’m hoping to refinance in five years or less. And we’ll be in the house for about 10 years so we could also sell. Hopefully prices have bottomed so we won’t be underwater then.”
In the second year of the U.S. housing recovery, the loans that helped trigger the housing bust are making a comeback. Applications in late June rose to the highest level since 2008 after the Federal Reserve sent fixed rates surging by signaling it may curtail bond buying credited with pushing borrowing costs to the cheapest on record. The average 30-year fixed-rate mortgage jumped 1.2 percentage points in mid-July from May to the highest level in two years, adding about $200 a month to payments on a $300,000 mortgage.
“We’ve seen a shift in the way people look at adjustable-rate mortgages,” said Cameron Findlay, chief economist of Discover Financial Service’s home-loan unit. “They’re still skeptical about using ARMs, given the role they played in the financial crisis, but the sticker shock of what fixed rates have done is making them look for alternatives.”
ARMs, loans with interest rates that adjust after initial fixed periods, usually of five, seven or 10 years, helped fuel the housing bubble and contributed to soaring defaults in 2008 that sent the economy into a tailspin.
In addition to loose underwriting standards that extended mortgages to people who couldn’t pay, variations included loans that had interest-only periods or initial teaser rates that became known as exploding ARMs when the rate spiked. Lending was based on the presumption that house prices would keep rising and the debt could be refinanced before onerous terms kicked in.
“When you give unqualified buyers a rate they won’t be able to afford based solely on the presumption that home prices will always go up, it’s not going to end well,” said Keith Gumbinger, vice president of HSH.com, a Riverdale, New Jersey-based mortgage website.
Home prices peaked in mid-2006 before starting a plunge that stripped a third off the value of properties in the biggest real estate bust since the Great Depression.
Mortgage qualification standards have since become the tightest in at least two decades, with lenders often requiring 20 percent down payments. The average FICO score of an ARM borrower is about 771 on a measure that ranges from 300 to 850, said Guy Cecala, publisher of Inside Mortgage Finance. That’s better than the 755 average FICO score for fixed-rate borrowers, he said.
The biggest ARM lenders are Wells Fargo & Co., based in San Francisco, JPMorgan Chase & Co. in New York, PHH Corp. in Mount Laurel, New Jersey, and Bank of America Corp. based in Charlotte, North Carolina, according to Cecala.
Home prices also are gaining at the fastest pace since the boom, with values up 2.4 percent in the second quarter from the previous three months, according to Zillow Inc., the biggest second-quarter gain since 2004. Sales of new properties rose more than forecast in June to the highest level in five years, the Commerce Department said today.
New lending regulations stemming from 2010’s Dodd-Frank Act effective in January include an “ability to repay” measure that requires lender to make sure fixed-rate and ARM borrowers have the ability to make good on their payments.
Since the rules for ARMs usually allow borrowers to qualify on the loan’s initial rate, some may not be able to afford their mortgages after the fixed period ends.
For now, ARMs are helping borrowers lower interest payments and reach for more expensive homes after financing costs rose.
In the last week of June, the dollar value represented by ARM applications accounted for 16 percent of mortgage requests, the highest share since July 2008, two months before Lehman Brothers Holdings Inc. collapsed, according to Mortgage Bankers Association in Washington.
Mark Baudler, a San Francisco attorney, last month traded a 30-year mortgage with a 4.5 percent fixed rate for an adjustable loan at 2.5 percent, cutting his $5,500 monthly mortgage bill almost in half.
“I’m going to take the money I save and plow it right back into the mortgage,” said the partner at Wilson Sonsini Goodrich & Rosati, a law firm that specializes in securities and intellectual property law. “If the rates go nutty when the loan adjusts, I’ll be able to handle it.”
Others, like Los Angeles buyer Lim, are basing their decision to get an ARM on their plans to move from a property in a set number of years. Vivian Cohn in Hollister, California, lowered her monthly mortgage payments to about $940 from $1,400 in May when she took out a 5-1 ARM, meaning the rate is fixed for the first five years. After that, her 2.2 percent initial rate could adjust as much as 5 percentage points higher.
Cohn doesn’t see the threat of a rate change as a problem. When she retires in two years, she and her husband are moving to Panama, Cohn said. If they can’t sell the house at that point, they’ll rent it for the following three years and sell then, before the loan adjusts, said the 60-year-old human resources manager at a Silicon Valley company.
“A fixed rate isn’t for everybody,” Cohn said. “We know we’re moving so there’s no point in paying for a guaranteed rate if we won’t use it.”
Regardless of how confident borrowers are of their plans to stay in a home for a limited time, there are no guarantees home prices will provide them the opportunity to refinance or sell, said Erin Lantz, director of Zillow’s Mortgage Marketplace, an aggregator of loan rates.
“On a national basis, home prices probably will continue to rise, but it’s more difficult to predict by region,” Lantz said. “If you go underwater, you’re going to have to bring money to the table to get out of that mortgage.”
Another assumption of ARM applicants is that their income will be higher by the end of the loan’s fixed period so they can handle higher payments if they can’t sell, said Henry Savage, president of PMC Mortgage Corp.
“When you start making those calculations, you’re playing golf in the dark,” said Savage.
Borrowers like Baudler say they don’t have to worry where home prices will be when their loans adjust. He has the assets to weather rate changes at the end of his seven-year fixed period and plans to use his mortgage savings to pay off the loan in nine years. It was a cheaper alternative to using a 15-year fixed mortgage, he said.
“I’d rather put that money into paying off my house, and have the safety of that, rather than put it into the stock market and risk what happened in 2008,” he said.
With fixed rates projected to gain through the next two years, ARMs will underpin about one-tenth of the market, according to Freddie Mac. That will enable some people to buy a bigger home with an ARM they couldn’t have gotten with a fixed, said Savage.
“Sometimes it’s a tough choice to go for the fixed rate when you know you could buy a bigger and better house with an ARM,” Savage said. “It’s the same dilemma we saw before the housing crash.”
A 1 percent change in fixed rates means home shoppers who last month qualified for a $400,000 house may now have to look at properties priced around $350,000.
While moving to an ARM helps them purchase the more expensive property, when the loan adjusts the interest rate on a typical ARM could go as high as 8.5 percent.
“When people want a bigger house for their families and they’re sitting across from loan officers in suits assuring them an adjustable is a financially sound choice, it’s not surprising a lot of people believe it,” said Jay Westbrook, a law professor at the University of Texas.
No one can predict the future rate environment with assurance, including homebuyers, he said.
“Jamie Dimon can’t predict what will happen in five years,” said Westbrook, referring to the chief executive officer of JPMorgan, the biggest U.S. bank. “Neither can homebuyers who are thinking about getting an adjustable.”
Quicken Loans Inc. last week offered a 3.3 percent rate for an ARM with an initial fixed period of 7 years, after which it could adjust as much as 5 percentage points higher. Their rate for a fixed loan was 4.5 percent. JPMorgan offered a 3.3 percent rate for a five-year ARM and 4.4 percent for a fixed-rate loan.
In Los Angeles, Lim is happy to be locked at a 4.6 percent rate for an adjustable mortgage that is fixed for 10 years, about a percentage point cheaper than a loan fixed for 30 years, he said. Leah Guerra, the agent with Rodeo Realty who is helping Lim with the purchase, said using an ARM is a calculated risk that pays off when it’s right.
“It’s a bet that prices will appreciate, that your income will stay the same or increase and that rates will stay stable,” Guerra said. “It’s a bet that confident people make.”