Consider the Risk
Even though mortgage interest rates are still (historically speaking) quite low, they’re headed back up.
On April 14, 2022, Freddie Mac rang the alarm on its Mortgage Rates page:
This week, mortgage rates averaged five percent for the first time in over a decade. As Americans contend with historically high inflation, the combination of rising mortgage rates, elevated home prices and tight inventory are making the pursuit of homeownership the most expensive in a generation.
With prices so high, buyers may be tempted to consider adjustable-rate loans with bargain rates.
Wondering whether an alternative to a fixed-rate mortgage could be worth it? Read on.
Fixed-Rate Mortgages Are More Popular. Here’s Why Most Buyers Don’t Take the Adjustable Rate.
Adjustable-rate mortgages (ARMs) attract home buyers with teaser rates. But the interest rate changes over time. While adjustable rates can go up or down, when federal interest rates are rising, they’ll go up. Rates are on a (suddenly sharp) upward trend from a deep drop related to the early months of Covid-19, when the Federal Reserve pressed rates down to keep the economy from stalling.
So, the point is that an adjustable-rate mortgage will start low, but the lender will expect to extract more from the borrower later.
In contrast, the ever-popular 30-year, the interest on a fixed-rate mortgage stays where it is, regardless of how the federal benchmark rate may change. Most buyers opt to lock in one rate for the life of the loan — especially at times like this, when interest rates are on the rise.
Basically, How Does an ARM’s Rate Adjustment Work?
A borrower has to be aware of the payments going into the loan, and the payments that will be expected later, after the interest rate goes through its scheduled adjustments. There are some unknowns in this. Although the amounts of the rises are generally capped, we still can’t tell what the ultimate rate will be for an ARM initiated today.
If the ARM is designated 5/1, the rate stays where it is for its first five years. That’s the teaser period. After that initial, predictable period, the interest rate changes (subject to the loan’s interest rate cap) every one-year period. So, the upward interest rise will happen quickly.
With an ARM designated 5/6 month, again, the rate stays where it is for its first five years. After that initial period, the adjustment happens every 6 months! The lender is therefore able to recalibrate the interest rate quickly as the federal rate changes. The overall cap on how much the loan can change since its initiation is usually five percentage points, although it’s sometimes even higher.
For obvious reasons, in the above examples, a homeowner would want to try to pay off or refinance the loan within five years. Refinancing can be as difficult as getting financing in the first place. And most people don’t want to depend on their future ability to refinance if interest rates are clearly on a steep climb. This is why selecting an ARM is not the best idea for most home buyers now.
The Riskiest ARMs Became Unavailable in 2014.
Most of our readers will recall what they (or their parents) went through during the 2008 housing crisis. That year, ill-fated investments, including high-risk mortgages, caused the economy to collapse. Many ordinary people wound up in foreclosure. They had agreed to adjustable-rate mortgages because they could initially afford them. But in three or five years, the interest rates adjusted upward, and became unbearable for many homeowners.
To keep this from happening again, Congress passed the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act. By 2014 there were rules in place to keep major loan sponsors (Freddie Mac, Fannie Mae, VA, FHA and others) focused only on Qualified Mortgages (“QM loans”). The high hurdles to the approval goal line generally make these loans safer for borrowers.
An ARM can’t qualify unless it holds its teaser rate for at least five years. That’s why we’re talking about 5/1 or 5/6 month ARM loans in this article. A qualified ARM also directs a borrower to pay off the principle loan amount plus the interest on that principle on a regular schedule. That’s called the qualifying repayment requirement.
Borrowers should be especially wary of ARMs that aren’t QMs. Non-QM loans don’t meet the U.S. Consumer Financial Protection Bureau’s standards. Non-QM ARMs, which can have very low payments, looked like:
- Flexible payment ARMs. Borrowers who underpay their mortgages with flexible or payment-optional mortgages can soon be overwhelmed by snowballing debt. The Consumer Financial Protection Bureau sidelined these loans when it issued its Qualified Mortgage standards in 2014.
- Interest-only ARMs. A borrower who isn’t paying off the loan principal as well as the interest during the teaser period can’t build home equity. And when the interest-only period stops, the borrower’s rate changes and the principal must be paid down — so the borrower faces heavy monthly debt payments.
Proponents of interest-only mortgages might claim that where property values are soaring, buyers can build up equity even without paying down principal. They also might claim that everyone should have the right to take risks. Here are the responses to these claims.
If borrowers get low-budget mortgages and their home prices values cool or interest rates spike, the borrowers have to avoid going underwater — owing more on their homes than the property is worth. A basic level of consumer protection can avert a situation in which people get in over their heads and the government winds up bailing out the banks that lent too flexibly. In 2008, people were horrified when banks were bailed out with taxpayers’ funds. Flexible mortgages in default were a big part of that financial crisis.
So, Why Would Anyone Ever Get an Adjustable-Rate Mortgage? Here Are Some Special Circumstances.
Investor-buyers might look to ARMs to get in at a low mortgage rate and then refurbish and sell, or get new funds together to pay off the ARM in its initial period. Regular home buyers might select ARMs when they have big changes happening in their lives in the next five years and they know they have to sell or refinance then in any case.
Say you are being moved by an employer during the ARM’s teaser period. In that case, an ARM might make sense.
Or say you are getting a major raise during the initial loan period. Or your kids will be out of college and into their careers, and you won’t need to be concerned about helping them financially any more. For people in these positions, grabbing an initial lower rate could make sense. But only if they’re willing to pay it down fast or refinance to a fixed-rate loan from a better position that they are sure they’ll reach. Homeowners who know they’ll be prepared to pay off the mortgage faster — and want to do so — can perhaps save a few bucks up front on interest. Of course, if the buyer can pay off the whole mortgage during the teaser period, so much the better.
Getting a Qualified ARM Mortgage Because of Special Circumstances? Where Will the Interest Rate Be in 5 Years?
We don’t have a crystal ball, but we do know interest rates go up whenever the Federal Reserve tightens the supply of money. And the Fed is on a tightening roll now. So, locking in a fixed rate makes sense for most buyers today.
With a fixed-rate mortgage, you get a stable, predictable monthly payment schedule. Assuming rates keep rising, you get an increasingly better deal as time goes on. You won’t have to pay more because the lender is adjusting for higher federal rate levels.
As you now know, fixed-rate mortgages are well suited to borrowers who will live in their homes for many years. Could they more easily put a home purchase into their budgets with a low ARM rate, and manage to pay off the loan before the rates adjust? For some people, this will work.
So, qualified ARMs do have an important purpose. But life isn’t always predictable, so most buyers prefer to lock in a rate they can count on for the life of the loan.
Supporting References
FreddieMac.com: Mortgage Rates Hit Five Percent (Apr. 14, 2022).
Consumer Financial Protection Bureau: Adjustable-Rate Mortgages – Find out how your payment can change over time.
Jon Healey Los Angeles Times: Mortgage interest rates are rising. If you’re looking at adjustable-rate loans, know the risks (Apr. 4, 2022).
Miranda Marquit for Next Advisor (in partnership with Time): ARM Loans Aren’t Worth the Risk When Mortgage Rates Are Low. Here’s Why, According to Experts (Dec. 23, 2021).
And as linked.
Photo credits: stevepb, Michael Burrows, and Anete Lusina, via Pexels.