Years after their fall from grace amid the subprime mortgage crisis, adjustable-rate mortgages (ARMs) are making a steady march back toward the mainstream.
According to a December 2018 report from Ellie Mae, a software company that process mortgages, the percentage of home purchases that used adjustable-rate mortgages ticked up to 9.2%. Not only was that the highest level in 2018, it was also an all-time high since Ellie Mae began tracking such data back in 2011.
While many personal finance and industry experts view this resurgence with concern, warning consumers to continue avoiding ARMs like the plague, that’s not the sentiment in all quarters.
ARMs do have their supporters, despite their involvement in the housing market crash that triggered the Great Recession. Here’s a closer look at the pros and cons of using an ARM to purchase a home.
What Are ARMs, and Why Are They Coming Back?
For those who are unfamiliar, ARMs are mortgages with an adjustable interest rate. They offer borrowers a lower initial interest for a fixed period of time, typically three, five, or seven years. After that, the rate fluctuates based on the market. A 5/1 ARM, for example, will have a fixed interest rate for the first five years, then reset to a new rate every year thereafter based on market conditions.
ARMs have been getting a boost in popularity as rates on 15- and 30-year fixed-rate mortgages climbed throughout 2018. The average rate on a 30-year, fixed-rate mortgage is back down to 4.14%, according to Freddie Mac, after hitting a high of 4.94% in November. However, average rates in the mid-3% range are probably long gone, and most experts expect rates to inch upward in coming years.
In general, when the economy improves, borrowing gets more expensive. ARM mortgage rates, however, often start out about 0.5% lower than fixed-rate loans.
In such an environment, borrowers looking for the lowest mortgage rates are increasingly opting for ARMs.
“I’m not surprised to see ARMs making a comeback. As housing prices continue to rise, many potential homeowners are simply getting priced out,” said James Stefurak, CFA and founder of Florida-based Monarch Financial Research.
The Difference Between Present Day and the Run-Up to the Great Recession
For those who may now be considering an adjustable-rate mortgage thinking the lower interest rate will help them qualify for more home, think again, says Mike Ferraro, area manager for Bank of England Mortgage.
“One of the popular reasons people did an ARM prior to 2008 was to qualify for more of a house. At that time, lenders qualified borrowers at the initial lower rates with no consideration of any future rate increases,” explained Ferraro. “This led to many consumers taking adjustable-rate mortgages that per today’s standards would have actually been qualified for much less.”
Today, however, mortgage lenders qualify borrowers for ARMs based on a higher interest rate calculation, rather than the initial rate that’s offered, Ferraro said.
And overall, mortgage underwriting is far, far stricter now, said James McGrath, co-founder of the New York City real estate brokerage Yoreevo.
“Coming out of the downturn, ARMs got a bad reputation for good reason but the problem was more about underwriting rather than the product itself,” explained McGrath. “If you can’t afford a loan, you’re going to default, it’s as simple as that, and during the housing bubble, borrowers were able to lie about their income and banks didn’t care if they did.”
The Drawbacks of Adjustable-Rate Mortgages
Not having control over fluctuating interest rates can be a challenging experience, one that can sometimes end in disaster for the homeowner, as evidenced by the aforementioned housing crisis.
Borrowers who opt for this type of mortgage need to be prepared for, and comfortable with, a potential rollercoaster ride. When ARM fluctuations occur, it could translate into significantly higher mortgage payments almost overnight, which can be troublesome for low-income borrowers in particular.
“If rates move up quickly the borrower could spend hundreds in additional interest payment dollars in as little as one year,” said Matt Seu, principal at the financial services firm Actualize Consulting. “This increases the borrower’s chance of default significantly.”
If all of that’s not clear enough or doesn’t give you pause, spend a moment chatting about the topic with money expert Dave Ramsey.
The renowned financial advisor expresses his disdain for such mortgages in no uncertain terms, urging home buyers to avoid ARMs at all costs.
“I would never under any circumstances take an adjustable-rate mortgage,” said Ramsey. “Ask yourself this: Which way do you think the rates will ‘adjust?” If you said up, you’re right.”
“This isn’t rocket science,” Ramsey added. “The bank offers you a lower interest rate to get you in, and when rates adjust, they almost never adjust down… Make sure a house is a blessing and not a curse. Save for a down payment and get a 15-year fixed-rate mortgage and pay it off as soon as you can.”
The Benefits of Adjustable-Rate Mortgages
Still, there could be benefits to using ARMs depending on a borrower’s financial situation.
The lower rates at the front of the loan make it possible for some new homebuyers to purchase a home and still have enough money available for other needs or renovations in their new home.
In addition, for high net worth borrowers, ARMs offer a lower interest payment allowing them to invest the difference, said Seu. When rates rise, this type of borrower can quickly refinance into a fixed-rate loan or simply pay off the note entirely.
How to Decide if an ARM Makes Sense for You
So how to decide if an ARM might be a good choice for you? Proceed with a good deal of caution, do your homework, and understand all of the possible outcomes.
In particular, analyze what the payment difference would be in today’s interest rate environment between an ARM and a fixed-rate mortgage.
“In certain interest rate environments, buyers should choose ARMs,” said McGrath. “In particular, when short-term interest rates are significantly lower than long-term interest rates, they make a ton of sense. Please note, that is not the case today as short-term interest rates are fairly close to longer term interest.”
Yet another factor to consider is how long you intend to be in the home. If you plan to sell the home before the introductory fixed rate expires, an ARM could make sense (though plans do change). If the answer is the rest of your life, however, then an ARM is not likely to be a good choice for you.
“If a consumer plans to be in a home their entire life, then they should not do these loans just for the initial lower rate, as it will surely adjust higher in the long run,” said Ferraro.
However, ARMs can be a good choice for people who know with some degree of certainty that their income is going to be higher in the future.
“If home loan rates rise and the monthly mortgage payment goes up, they know they can afford the higher payment,” explained James Stewart, a mortgage originator with national lender and servicer Planet Home Lending.
Examples of such situations might include:
- You are finishing school and going into a high paying career with solid job prospects.
- A stay-at-home partner or spouse will be going back to work when children start kindergarten.
- Your secure job has predictable pay raises based on years on the job.
In addition to those situations, there are a few other instances in which an ARM might make sense, added Stewart.
These include buyers who are planning to pay off the home loan before the ARM adjusts, because they plan to move up to a new home or location, and buyers who intend to religiously pay extra principal each month on their mortgage.
“When an ARM gets adjusted, the new payment is based on the amount still owed,” said Stewart. “Reducing what you owe may give you lower payments.”
The bottom line, however, is this: When agreeing to an ARM, you’re taking on the risk that the monthly payment will rise, and it may rise quickly and significantly.
If that added risk is going to cause you to feel overly stressed, an ARM may not be for you, said Stewart.
Mia Taylor is an award-winning journalist with more than two decades of experience. She has worked for some of the nation’s best-known news organizations, including the Atlanta Journal-Constitution and the San Diego Union-Tribune.