The bad boy home loan from the foreclosure crisis is back.
Demand for adjustable-rate mortgages, or ARMs, hit a 14-year high last week, according to the Mortgage Bankers Association, as price-squeezed homebuyers sought out cheaper options to combat soaring borrowing costs.
But with interest rates rising, could these mortgages again become a problem like they did in the housing crash that preceded the Great Recession? No, experts say, because these are a more stringent loan than their predecessors, but they still may not be for everyone.
“Before it was very, very easy to get a mortgage. You could lie about your income and often get a mortgage,” Clare Trapasso, deputy news editor at Realtor.com, told Yahoo Money. “Today, lenders are much more careful about who they're giving mortgages to.”
‘ARMs are a more complex mortgage’
The share of ARMs made up 10.8% of overall loans last week, according to MBA, the highest point since March 2008 and more than doubling the 4.4% of purchase application activity for the week ending January 27. (The share ticked back down to 10.3% this week.) Before then, ARM activity was even less.
It's no big surprise, given the rate on these loans are a full percentage point lower than the rate on the 30-year fixed mortgage, which has skyrocketed since the start of the year.
Last week, the rate on the 30-year fixed mortgage — by far the most popular home loan used in home purchases — hit 5.3%, according to Freddie Mac, the highest level since July 2009 and up from 3.22% in the first week of the year.
By comparison, the average 5/1 adjustable-rate mortgage stood at 3.98% last week.
Historically, ARMs have been an attractive alternative for borrowers looking for a lower initial rate when compared to traditional fixed-rate mortgages.
Unlike traditional mortgages, which have a fixed interest rate for the life of the loan, the payment on an ARM can fluctuate over time. The rate resets after a previously agreed upon period and will reflect current interest rate conditions – resulting in higher or lower monthly payments.
“ARMs are a more complex mortgage product than a traditional fixed rate 15- or 30-year mortgage, so it’s not a bad thing for homebuyers to approach ARMs with some degree of caution and a deep look at if an ARM makes sense for them,” Robert Heck, vice president of mortgage marketplace Morty, told Yahoo Money. “Everyone’s situation is different, but ARMs could be an especially attractive option to homebuyers that don’t plan on living in their home for more than a few years.”
‘Today’s ARMs are different’
The ARM earned a bad rap over a decade ago because of the role these home loans played in the housing crash.
Back then, the fixed period on these mortgages could be as little as one to two years. Many lenders didn’t require borrowers to verify their income, either. And the especially risky ARMs offered an option for borrowers to pay only the interest on their loan — nothing toward principal — or even worse, a payment option that wouldn’t even cover the interest, allowing the outstanding balance to balloon.
But since the Great Recession, lending practices have tightened – especially during the pandemic. That means borrowers who want to snag an ARM, or any other type of loan for that matter, will face stricter criteria to qualify. Underwriting guidelines tied to ARMs have also notably changed.
“Today’s ARMs are different in that they are better regulated than those originated in 2008. The newer regulations cap rate adjustments, which limit percentage increases per period and over the life of the loan, minimizing the risk of payment shock that homebuyers may experience,” Brian Rugg, chief credit officer at loanDepot, told Yahoo Money. “Credit and income criteria have also become more restrictive, which enables lenders to validate that an ARM will be an affordable, long-term solution for their borrowers.”
Who should get an ARM?
Still, that doesn’t mean ARMs are a good choice for every homebuyer.
If you’re looking for a lower rate, an adjustable-rate mortgage can be a good opportunity to get a break on your monthly payment – but it won’t last.
“Borrowers for whom an ARM might be suitable are folks that are looking to stretch themselves into a home at a time when things aren't overly expensive,” Keith Gumbinger, vice president of HSH.com, told Yahoo Money. “So this could include first-time homebuyers. These buyers probably aren't going to be in their homes forever. At some point either you'll be moving to a bigger home.”
According to Gumbinger, first-time buyers can benefit from the low-interest of an ARM during the fixed-period before they trade up. But before making any moves, borrowers considering an adjustable-rate mortgage should really do their homework and use an amortization calculator to check how their mortgage payments may fluctuate in six years time and whether they’ll be able to afford it.
“Say, in five years you’ll be paying $1,150 a month on your mortgage. If rates go up by two percentage points – ask yourself if you’ll be comfortable paying $300 more,” Gumbinger said. “On the other hand, if the interest rate cycle turns favorable [with rates going down], these borrowers can also opt for a refinance. We've certainly had that a number of times over the last 15 years.”
Gabriella is a personal finance reporter at Yahoo Money. Follow her on Twitter @__gabriellacruz.