No Farewell to ARMs: High Rates Are Driving Borrowers Back to Adjustable-Rate Mortgages
"Adjustable-rate mortgages can [have rates] significantly lower than their fixed-rate counterparts, real estate experts say, sometimes as much as a full percentage point, a difference that can potentially save home buyers thousands of dollars annually," said The New York Times on Oct. 1. "The ARM, as the loan is known, also comes with the risk that rates will continue to climb, hurting owners when the loan resets."
On Sep. 24, the National Association of Realtors reported, "The share of applications for ARMs [as a proportion of all mortgage applications] jumped to nearly 10% last week as the 30-year fixed-rate mortgage rose above 7%, according to the Mortgage Bankers Association."
That figures. As rising mortgage rates squeeze home buyers, often making their dream homes unaffordable, many are likely to turn to less costly forms of borrowing, including ARMs.
What About the Risk?
As The Times suggested, ARM borrowers run the risk of their mortgage rates rising once their initial fixed-rate period ends. But there are two main reasons why that risk is limited:
- Those with longer fixed-rate periods (five, seven, or even 10 years) may well move before a higher rate can kick in. And, even if they don't, they could refinance to a fixed-rate mortgage (FRM), assuming rates drop at some point during that period.
- Modern ARMs tend to have caps on the amount that the mortgage rate can rise, both at each individual reset and overall through the lifetime of the loan. So, monthly payments could rise at each reset, but not necessarily up to the full prevailing rate. And, of course, they might even fall if prevailing rates are lower.
Of course, neither of these removes all the risks implicit in an ARM. Suppose circumstances change and one can't move or refinance before the loan rate resets. Or what if mortgage rates power higher for years on end, which is unlikely but not impossible?
So, home buyers need to understand their new mortgages' terms and conditions — and especially those caps — and be sure they can cope with worst-case scenarios before they sign up.
Is Demand-Led Pricing in Play?
The Times talked about ARMs' rates being lower than those for FRMs, "sometimes [by] as much as a full percentage point." So, an ARM might offer a rate of 6.55% while a conventional FRM's average rate is 7.55%.
Such a percentage-point difference certainly can arise. But it was far from the case on Oct. 6, when this article was written.
That morning, the average 30-year fixed conventional rate was 7.55%, according to our daily rates report. But the average 5/6 ARM rate was 7.06%, meaning only a half-point difference.
Of course, the gap between rates for different types of mortgages naturally narrows and widens all the time. But such a small gap makes us wonder whether lenders are using demand-led pricing.
That's when the supplier of goods or services dynamically adjusts pricing to reflect demand: The higher the demand, the higher the price. With ARMs, the price is the interest rate.
"McDonald’s is increasingly using artificial intelligence to guide menu prices across the U.S. and some global markets, a plan that aims to boost headquarters’ profit but risks alienating customers and attracting antitrust scrutiny," reported Reuters on Sept. 29. "One pricing factor supercharged by AI: an estimate of how much each store's patrons are willing to pay."
So, for example, a Big Mac and fries may cost less in an outlet near a college when students are on vacation, and demand is lower.
Are mortgage lenders applying demand-led pricing to ARMs? Or are they genuinely worried about ARMs' stability, so they currently require additional risk-based pricing? We can't be sure.
Going ARMless: Alternatives to Adjustable-Rate Mortgages
There are alternatives to ARMs. Readers will remember that the average 5/6 ARM rate was 7.06% on Oct. 6. But it's better to compare annual percentage rates (APRs) because those include all loan costs. And that APR was 7.14%.
Here are some other APRs that day:
- 15-Year Fixed: 6.82%
- 30-Year Fixed VA: 7.2%
- 30-Year Fixed USDA: 7.14%
These can help only some readers. A 15-year FRM will have a much higher monthly payment than a 30-year one because one's spreading payments over half the time. So, only those with high cash flow can consider these.
Government-backed VA loans are available only to veterans, current service members, and some surviving spouses. But those who are eligible will benefit from a fixed rate for 30 years and a 0% down payment, which are often well worth the tiny premium.
USDA loans are backed by the United States Department of Agriculture and are available to those with low-to-moderate incomes buying in rural and certain suburban areas. Their APR happened to be the same that day as that for a 5/6 ARM, but again come with the security of a fixed rate over 30 years. And they require zero down payment as well.
Those for whom the above aren't a good match can still minimize their mortgage rate and monthly payment by working on their financial profile. Boosting one's credit score, reducing one's debts, and putting down more than the minimum down payment can all earn one a lower rate than otherwise.
Alternatively, ARMs can be a sound strategy for those able to manage and live with the risk.
