The demand for homes remains robust. Despite 30-year mortgages being firmly above a 5% interest rate, mortgage applications for home purchases increased 5% in mid-May. That’s not surprising because springtime is the busiest season for home purchases. What is different this year is that buyers are turning to adjustable rate mortgages in higher numbers than at any time in the past 14 years.

Mid-May is seeing 30-year interest rates at about 5.50%, while ARMs are running at about 4.47%, according to the Mortgage Bankers Association. The difference in the monthly payment for a $300,000 mortgage is almost $200 less for an ARM. Early this year, before interest rates began to rise, ARMs made up about 3% of all purchase applications. Now, the share of ARMs is 11% of overall mortgage loans.

How to Read an ARM

ARMs begin with a set interest rate for a specified time and then the rate is adjusted periodically. The key to knowing how an ARM will adjust is in the name. A 5/1 ARM means the introductory rate is set for five years and then adjusts annually in most cases. Common ARM terms have introductory rate periods of 3, 5, 7, or 10 years.

Besides the introductory period and frequency that the interest rate can be adjusted, there are other important numbers that buyers need to understand. An important feature is the cap structure. A 7/1 ARM with a 5/2/5 cap structure means that for the first seven years the rate is unchanged, but in the eighth year, your rate can increase by a maximum of 5 percentage points (the first "5") above the initial interest rate. Every year thereafter, your rate can adjust a maximum of 2 percentage points (the second number, "2"), but your interest rate can never increase more than 5 percentage points (the last number, "5") over the life of the loan.

A Short History of ARMs

Adjustable-rate mortgages were a significant contributing factor to the Great Recession foreclosures and short sales. When interest rates rose, monthly payments increased on ARMs, leaving many borrowers unable to pay their mortgages. Approximately 20% of home loans were adjustable in the ten years leading up to the recession. At that time, the so-called teaser interest rates (which lasted for the first year or two) made a home seem affordable but soon ballooned into mortgage payments that homeowners could not pay.

Following the recession, the number of ARMs dropped below 1% of mortgages being written but by 2018 had crept back up to about 6% of all loans. The number of ARMs stayed at low levels for a few years because of historically low interest on 30-year mortgages. In January of 2021, Ellie Mae estimated the market share for the ARM mortgage at about 4% of all mortgages sold. But this spring, the number of ARM loan applications has again been on the rise – increasing slightly each month.

However, the rules on ARMs have changed. Some of the riskiest features - prepayment penalties that keep borrowers locked into loans with expensive terms - are gone. Loans that qualify applicants based on teaser rates are no longer allowed - today’s underwriting guidelines must consider a borrower’s ability to repay the mortgage not just at the teaser rate but for the life of the loan. And the most popular ARM mortgage - the hybrid with introductory rates that can be fixed for three to ten years - is further backstopped with caps on rate increases and lifetime limits to keep loans affordable. ARMs are now better regulated by the government and have both periodic and lifetime caps so that your rate can only adjust a certain amount each year and over the life of the loan – usually not more than 5%.

The Best Time to Use an ARM

Time will tell, but logic suggests that today’s ARMs are less risky than they have been in the past. Still, there is risk involved. A 5/1 ARM with a 5/2/5 cap structure and an introductory interest rate of 4.47% means that your interest rate could go up to 9.47%. On a mortgage that started at $300,000, that huge jump in interest could mean as much as an $860 increase in the monthly payment beginning as soon as year 6.

If you are a person that likes to be prepared for the worst-case scenario, you might want to plan to be done with the ARM before the introductory period ends. For someone with a 5/1 ARM, that typically means selling the house or refinancing in less than 6 years. Refinancing into a 30-year fixed rate loan is a strategy but you don’t know what the interest rate will be at that time. Chances are that it will be close to the same as the ARM. That makes a refinance strategy risky.

ARMs can be a viable choice for first-time buyers or any buyers that are reasonably sure that they will sell the house before the introductory period ends. You don’t know what interest rate you’ll pay for your next house, but you do know that you won’t see a change in the interest rate for the ARM.

However, today’s ARMs do not appear to carry the same level of risk as they did back in 2008 during the Great Recession. This was a time when people couldn’t sell houses under almost any circumstance. People that couldn’t pay their mortgages were losing their homes to foreclosure and short sales. Jump forward to today’s housing market. Demand for home purchases is extremely high today and significant value appreciation gives new buyers instant equity. As long as equity and demand remain high, short sales and foreclosures should be few and far between. Even if homeowners can no longer afford their ARM mortgage, they can sell for a profit.

What are your thoughts about ARMs today? Please leave your comments.

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