Adjustable-rate mortgages, known as ARMs, are back, despite having earned a bad reputation at the height of the housing crisis.
Post-crisis borrowers saw them as risky because of their changing interest rates, and blamed the glut of foreclosures on the inability of homeowners to handle higher payments when the loans reset.
“ARMs became a four-letter word after the housing crisis,” said Ann Thompson, a retail sales executive for Bank of America in San Francisco. “They got a bad rap and were lumped in with ‘pick-a-payment’ loans, which allowed people to pay as little or as much as they wanted on their mortgage.”
Lately there’s been a resurgence in ARMs. In January 2019, 8.6 percent of new mortgage loans had an adjustable rate, compared with 5.5 percent in January 2018, according to Ellie Mae, a software company that processes 35 percent of mortgages in the United States.
One reason for the resurgence could be the safeguards in place that make today’s ARMs less risky than those approved during the frenzied days before the housing bubble burst. Not only are there limits on how much a mortgage rate can adjust, but most ARMs today are “hybrid” loans with a fixed period followed by annual adjustments in the rate. Caps are in place to prevent the mortgage rate and payments from rising too fast.
Perhaps most important, lenders no longer qualify borrowers on the initial low payment. Instead, they qualify them based on what future payments will be after the rate adjusts.
“In the past, one of the most popular ARMs was a ‘2-28’ which was fixed for two years and then adjusted every year after that,” said A.W. Pickel, president of Waterstone Mortgage in Pewaukee, Wis. “Mortgage rates could go very quickly from an initial rate of 6.5 percent to 13.5 percent.”
Borrowers in those days were approved for ARMs without a down payment and with little documentation of their income and assets, which meant they lacked the equity to refinance and faced unsustainable payments when their rates increased.
“You used to see ARMs that adjusted every six months or every year from the very beginning,” said Claudia Mobilia, senior vice president of operations for Embrace Home Loans in Middletown, R.I. “You don’t see that anymore.”
The ARMs of the past also included a prepayment penalty that discouraged borrowers from refinancing, said Shawn Sidhu, a mortgage consultant for C2 Financial in San Jose, Calif.
“A lot of people with credit issues or who couldn’t afford the payments on a 30-year fixed-rate mortgage turned to ARMs to get into the housing market,” Sidhu said. “Those people were not good candidates for ARMs.”
While ARMs are safer than in the past, they still carry a risk of an uncertain payment in the future.
“The rates on ARMs can be significantly lower than on a fixed-rate loan, so I hope that buyers and homeowners who are refinancing consult a mortgage professional who can talk them through all their options,” Thompson said. “Lots of people don’t stay in their home for that long, so an ARM can make sense. They just have to understand what it could look like if they do stay after the loan adjusts.”
Most ARMs are 30-year loans, with a fixed rate for a time period followed by a rate that adjusts annually. ARMs are identified as 3/1, 5/1, 7/1, and 10/1 to designate the initial fixed period and how often the loan rate adjusts. A 3/1 loan is fixed for three years and adjusts once every year thereafter.
“Borrowers get a disclosure form that shows them what their maximum payments could be,” Mobilia said. “They need to talk to a lender to make sure they know how long the rate is fixed in the beginning, what their payment could be at the first adjustment, and how high the payment can go.”
There are three essential numbers to understand when comparing ARMs:
ARM rates are tied to the index, so if the index rate doesn’t increase, the mortgage rate won’t either. The rate could drop if the index rate declines. However, a loan may have a floor, which refers to the lowest possible rate. If it is a 2 percent floor, the rate can’t go lower than 2 percent no matter how far the index falls.
Mortgage rates vary daily, and the rate depends on numerous factors, including a borrower’s credit profile, the size of the loan and down payment, and the type of home. But ARM rates tend to be lower than 30-year fixed loan rates. Bankrate.com’s most recent survey of the nation’s largest mortgage lenders as of May 1 listed a 30-year fixed-rate loan at 4.09 percent, a 5/1 ARM rate at 3.96 percent, a 7/1 ARM rate at 4 percent, and a 10/1 rate at 4.18 percent.
When a loan resets, the payment will be based on the new loan balance, not the original loan amount. The payments will be amortized over the remaining loan term, such as 23 years in the case of a 7/1 ARM.
“This can be especially helpful if you’ve been making extra payments on the balance or paid a lump sum on the balance, because even if the rate is higher your payments may not go up if your balance is significantly lower,” Mobilia said.
Borrowers often think it’s easier to qualify for an ARM because of the lower initial payments, but qualifying for ARMs can be harder, Mobilia said.
“We’re typically looking for stronger borrowers who can put money down on the purchase or have equity if they’re refinancing and who have steady income,” Pickel said.
Many lenders require a higher FICO credit score and more cash reserves for ARM borrowers. The minimum FICO credit score for conventional ARMs is 620 and 680 for jumbo ARMs, which are for higher loan amounts. Many ARMs require a 10 percent down payment, but some lenders may require more or less depending on your credit profile and the loan program.
“From the lender’s perspective, ARMs are a little riskier because of their variable rate,” Sidhu said. “Typically, lenders want at least a 10 percent down payment and they want a FICO score of 700 or above. These loans really favor borrowers with an excellent credit profile.”
The most important factor in deciding whether an ARM is right for you is how long you plan to live in your home, Sidhu said.
“If you plan to move or refinance within a few years, then an ARM could be right for you,” he said. “The sweet spot for most ARMs seems to be seven years, which is not too short but gets you a lower rate.”
An ARM is not a good fit for borrowers who are risk-averse, Thompson said, because even those with the best intentions sometimes don’t pay off the loan or move as planned before the rate resets.
Pickel has a 7/1 ARM himself and thinks they can be beneficial when used appropriately, but says ARMs may not be a good fit for most first-time buyers or for elderly buyers with fixed incomes.
Mobilia agreed: “I don’t recommend ARMs for first-time buyers because they may not understand the risks. They need to get comfortable with managing a mortgage payment and the other expenses of homeownership. It can be harder to manage when the payment adjusts.”
But Craig Strent, chief executive of Apex Home Loans in Rockville, Md., said an ARM can be the right choice for some savvy first-time home buyers.
“For first-time buyers who are making down payments of 20 percent or more and who have a fairly good sense of how long they’ll be in a home, 10/1 and 15/1 hybrid ARMs are good options that carry all of the benefits of fixed rates and could save home buyers thousands of dollars over the life of the loan,” Strent said.
ARMs can also be problematic for borrowers whose salary is based on commissions, Pickel said, because their erratic income may not work with adjustable payments.
For borrowers who think they’ll stay in a home for longer than seven or 10 years or keep it as an investment, Thompson said, a fixed-rate loan makes more sense.
The important thing to remember, Thompson said, is that a mortgage is an individual decision. She recommends borrowers weigh how long they plan to stay in a house with their willingness to assume the risk of having their mortgage payment adjust in the future before choosing a fixed or adjustable home loan.