A type of mortgage that fell out of favor in the aftermath of the financial crisis is catching on again.
Adjustable-rate mortgage demand has surged this year, making up 12.9% of all originations last week, a postcrisis high. The loans allow borrowers to lock in a lower rate than they could get on a 30-year fixed-rate mortgage for five, seven, or 10 years before the rate readjusts to market levels. They’re catching on as conventional mortgage rates remain stubbornly high.
Read more: When will mortgage rates go down?
At today’s rates, ARMs can offer substantial savings. One popular type, a 7/6 ARM, which carries a fixed mortgage rate for seven years and adjusts every six months thereafter, had an average rate of 5.78% on Friday, compared to 6.35% on a 30-year fixed mortgage. But accepting the lower rate can come with added risks for borrowers because they’re giving up the certainty of a stable interest rate for the life of their loan.
These days, though, the risk looks increasingly worth it in a punishing market of near record-high home prices and elevated mortgage rates. Surveys suggest that many sidelined homebuyers want to see rates around 5.5% before they jump into the market. While 30-year mortgage rates remain far from that level, ARMs are close.
“A lot of people want to get reengaged with the market,” said Rick Palacios Jr., director of research at John Burns Research and Consulting. “At this point in time, they don’t care if it takes an ARM to get them there.”
Mortgage brokers and lenders say they’ve seen an uptick in prospective clients’ curiosity about ARMs. They have others who stand to benefit from an ARM but might not be familiar with the loans, or are wary because of their association with the 2008 financial crisis.
Many people who defaulted on their mortgages in the lead-up to the crisis had ARMs they couldn’t afford. Back then, ARMs often had two or three years of ultra-low “teaser rates” and then would adjust interest monthly. In many cases, after the teaser period expired, borrowers saw big rate hikes that left them on the hook for payments they couldn’t handle.
In the years leading up to the crisis, ARMs made up as much as a third of overall loan volume, according to Mortgage Bankers Association data.
Learn more: What is an adjustable-rate mortgage — and should you get one?
After the crash, ARMs fell out of favor. By late 2008, they were less than 1% of the market. Mortgage lenders tightened their requirements, and ARMs gradually came back into use — but at a fraction of precrisis levels. When rates on 30-year fixed mortgages were ultra-low, few borrowers bothered with ARMs because the savings were minimal. But they enjoyed a brief resurgence in 2022 when rates ratcheted from around 5% to 7% in just a few months.
The ARMs of today are different than those available two decades ago. As with all mortgages, qualification standards have grown more stringent. Borrowers typically need to have a high credit score, a large down payment, and enough income to cover loan payments even if their interest rate jumps. ARMs also typically come with longer intro rate periods — seven years is common, and five or 10 years is also often an option — and have caps on how much an interest rate can rise during one adjustment phase and over the life of the loan. Adjustments usually happen in six-month or one-year intervals, not monthly.
While additional safeguards protect borrowers from massive interest rate hikes, paying higher interest rates down the line remains a risk. Many people who take out ARMs now do so with plans to move or refinance before their fixed-rate period ends.
Learn more: Adjustable-rate vs. fixed-rate mortgage — which should you choose?
“Even if you plan to stay in your home forever, the probability that you may refinance in the next five, seven, or 10 years is probably pretty high,” said Scott Bridges, chief consumer direct lending production officer at Pennymac, one of the nation’s largest mortgage lenders.
Those sorts of borrowers can potentially save hundreds of dollars a month in interest payments by choosing an ARM over a higher-rate fixed loan, he added. Client demand has been growing: ARMs have made up around 15% of the company’s new business recently, up from around 5% a year ago.
Terry Roberts, branch manager of E Mortgage Capital in Columbia, Mo., said he still gets mixed reactions when he presents prospective borrowers with the ARM option and explains the potential rate savings.
“People seem to be warming up to the idea,” he said. But despite lending guidelines designed to make sure borrowers can afford future interest rate adjustments, some borrowers still fear they won’t be able to handle the higher payments.
“It’s a seed that was planted years ago that scares people to death,” Roberts said. “That’s your biggest fear — losing your home.”
While most customers worry about their rate jumping higher during an adjustment period, the opposite can happen too, especially when the Federal Reserve cuts rates. While 30-year fixed mortgage rates are influenced by — but not directly tied to — Fed actions, ARMs have a more direct link.
ARMs in their adjustment period are benchmarked to what’s known as the Secured Overnight Financing Rate, or SOFR. SOFR is closely tied to the federal funds rate, meaning that when the Fed begins cutting rates, as it did on Wednesday, SOFR follows. In that environment, ARMs in their adjustment period can have their rates reset lower.
Still, there’s no way to guarantee where interest rates will be years down the line. Financial advisers caution that while ARMs can make sense for people who are sure they’ll move or refinance before their adjustment period starts, they’ve seen plans change, and it’s important to consider the overall affordability of the loan.
Read more: Mortgage rate predictions over the next five years
“I have seen countless situations where someone will get an ARM, and then when that adjustment occurs, their finances get blown up,” said Alex Caswell, founder and chief executive officer of Wealth Script Advisors in San Francisco.
Marcos Zambrano, president of Andes Mortgage in Atlanta, said he’s been doing more ARM business in recent years as interest rates have risen. Recently, they’ve been most popular among repeat buyer clients who are familiar with mortgage basics and have sizable down payments that can help them land the lowest rates.
“Those who have experience are a little more open to the program,” Zambrano said. “And the programs like a big down payment — the bigger the down payment, the better the rate is going to be.”
Claire Boston is a Senior Reporter for Yahoo Finance covering housing, mortgages, and home insurance.
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