The Adjustable-Rate Mortgage Gamble Is Back
When Los Angeles resident Jung Lim went shopping for a bigger house for his expanding family, his lender offered him an adjustable-rate mortgage with an interest rate about a percentage point cheaper than a fixed loan. The professor of dentistry figures the money he’ll save makes up for the extra risk. “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,” says Lim, who’s trading up to a $1.12 million, four-bedroom house in the Sherman Oaks neighborhood. “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 under water then.”
At the height of the real estate boom, ARMs accounted for about a third of all mortgages issued. Home buyers gravitated to this type of loan on the presumption that the value of their properties would keep rising and the debt could be refinanced before their interest rates were adjusted upward. Some loans had interest-only periods or very low initial teaser rates that subsequently spiked.
Now ARMs are making a comeback. In the last week of June, the dollar value of ARM applications accounted for 16 percent of mortgage requests, the highest share since July 2008, according to the Mortgage Bankers Association. Helping whet appetite for the loans is the more than 1 percentage-point jump in the average 30-year fixed-rate mortgage since May.
“We’ve seen a shift in the way people look at adjustable-rate mortgages,” says Cameron Findlay, chief economist of Discover Financial Services’ 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.” The biggest ARM lenders are Wells Fargo, JPMorgan Chase, PHH Mortgage, and Bank of America, according to Inside Mortgage Finance publisher Guy Cecala.
The profile of ARM borrowers has changed in the wake of the crisis. Today they have an average FICO credit score of about 771, says Cecala, better than the 755 average score for fixed-rate borrowers. Regulation stemming from the 2010 Dodd-Frank Act includes an “ability to repay” measure that requires lenders to make sure fixed-rate and ARM borrowers can make their payments. However, 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.
ARMs have a strong appeal for buyers who don’t plan to remain in their homes for long. Vivian Cohn of Hollister, Calif., 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. A human resources manager at a Silicon Valley company, Cohn, 60, says she plans to retire in two years and move to Panama with her husband. If the couple can’t sell the house, she says, they’ll rent it for a while and then put it back on the market before the five-year rate lockup expires. “A fixed rate isn’t for everybody,” she says. “We know we’re moving, so there’s no point in paying for a guaranteed rate if we won’t use it.”
Some in the real estate business caution that regardless of how confident borrowers are of their plans, there are no guarantees home prices will provide an opportunity to refinance or sell. “On a national basis, home prices probably will continue to rise, but it’s more difficult to predict by region,” says Erin Lantz, director of Zillow’s Mortgage Marketplace, a mortgage-shopping website. Another common, often misguided, assumption that ARM applicants make is that their income will be higher by the end of the loan’s fixed period, so they can handle bigger monthly payments if they can’t sell, says Henry Savage, president of PMC Mortgage. “When you start making those calculations, you’re playing golf in the dark,” he says.
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 than they would have been able to buy with a fixed loan. A 1 percent change in fixed rates means home shoppers who in June qualified for a $400,000 house may now have to look at properties priced at about $350,000. ARMs may enable some people to buy a larger home because their interest rate will usually be at least 1 percentage point lower than a fixed-rate loan. Yet rates on ARMs can rise dramatically, as much as 5 percent in the first year after the fixed term expires. “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,” says Jay Westbrook, a law professor at the University of Texas.