Why Adjustable Rate Mortgages Are Still Risky

Do you remember adjustable rate mortgages?

Rising interest rates are once again making these mortgages attractive to homebuyers, as the starting rate is usually lower than the rate for traditional fixed rate home loans. But they can be riskier.

Variable rate mortgages, known as ARMs, have interest rates that can go up or down over time. The rate starts low – typically lower than prevailing rates on 30-year fixed rate mortgages. But this can change after a certain period of time, say three, five or seven years, which makes monthly payments for borrowers more expensive.

ARMs have not been in high demand in recent years as rates on predictable fixed rate mortgages have remained low. They also gained a bad reputation during the financial crisis, when underqualified borrowers, attracted by initially low interest rates, were unable to sustain their payments when they rose.

Laws passed after the financial crisis have made ARMs “much safer and more transparent than they were before,” said Eric Stein, senior vice president of the Center for Responsible Lending.

Lenders, for example, are required to ensure borrowers have a reasonable ability to repay the loan, and ARMs no longer have prepayment penalties, so borrowers can more easily repay or refinance the loan. if they cannot afford higher payments. Still, he said, adjustable-rate loans come with inherent risks: “It’s up to the borrower to weigh them.”

But as interest rates — as well as house prices — rise this year, some borrowers are once again turning to ARMs to make their mortgage payments more affordable.

The average rate on a 30-year fixed-rate loan is now over 5%, up from less than 3% a year ago, according to housing finance giant Freddie Mac. Meanwhile, the median selling price for a previously owned home was around $391,000 in April, up nearly 15% from a year earlier, the National Association of Realtors reported. (And in some parts of the country, the typical selling price is much higher.) The combination of higher prices and more expensive mortgages means some buyers are feeling rushed.

“I get a lot more questions and inquiries about ARMs,” said Brian Rugg, credit manager at LoanDepot, an online lender. “It’s a very powerful tool to use, from an affordability perspective.”

Last year, no more than 4% of mortgage applications were for ARMs, said Michael Fratantoni, chief economist at the Mortgage Bankers Association. This year, he said, the share has risen to around 10%, driven by rising interest rates.

“For a borrower who wants to buy right away, they can realize significant savings” by choosing an ARM, he said. The average starting rate for ARMs with an initial five-year fixed-rate term was 4.04%, compared with 5.09% for a fixed-rate loan on Thursday, according to Freddie Mac. This difference represents savings of more than $200 per month on a $350,000 loan, at least to start with.

“It’s real money,” Fratantoni said.

Some borrowers use the savings to pay off their loan principal during the initial low-rate period, saving money over the life of the loan, Rugg said.

“If you can afford it, I recommend putting the savings aside or applying it to the principal,” he said.

The catch, of course, is that the rate may increase after the fixed rate period expires. Compared to ARMs available before the financial crisis, which offered low teaser rates and allowed for quick rate resets, today’s adjustable rate loans are safer, according to mortgage experts. They generally have a fixed rate period of at least three years and limits on the frequency and magnitude of the rate which can increase thereafter, such as a change per year of no more than 2 percentage points. And risky ARMs that allow borrowers to pay only the interest on the loan or choose their own payment amount are no longer widely available.

However, borrowers may see their rates increase after the initial repayment period. So they need to plan ahead to make sure they can afford larger payments if they can’t sell their home or refinance the loan. No one can say for sure what the rates will be in five to seven years, but right now they are going up.

“There’s not a lot of room to go down, and there’s a lot of room to go up,” said Martin Seay, associate professor of personal financial planning at Kansas State University.

It is wise to calculate what your payment would be if the rate increased to the loan ceiling. The Consumer Financial Protection Bureau has a guide to adjustable rate mortgages that can help you assess your loan. You can also calculate the highest payout yourself using online tools like the one offered by Freddie Mac.

ARMs are more complex than traditional mortgages, with more terms to understand and potential changes to follow, so borrowers should take the time to fully understand the terms of the loan.

“Be aware, educate yourself before you jump in,” said Linda McCoy, president of the National Association of Mortgage Brokers.

Here are the questions and answers about adjustable rate mortgages:

Q: What does it mean when an ARM is advertised as 5/1, 7/1 or 10/1?

A: The first number refers to the fixed rate period (five, seven or 10 years). The second is the number of times the rate can change after the flat rate period – once a year, in these examples. But loans whose rates can change every six months are also common. They are usually quoted as 7/6 months, 10/6 months and so on.

Some loans allow a larger increase on the first reset — often 5 percentage points above the starting rate — and then allow increases of no more than 2 percentage points, said Sean Bloch, a mortgage broker in Long Island. At New York. Some lenders take out ARMs based on the borrower’s ability to make payments at the initial fixed rate plus 2 percentage points, he said.

Most ARMs also cap the total increase over the term of the loan. So if the initial fixed rate is 4% and the cap is 5, the rate cannot exceed 9%, but that still represents a much higher monthly payment.

Q: When does an MRA make sense?

A: If you are confident that you will stay in the home for a relatively short period of time – less than the fixed rate period of the loan – an ARM may be a good idea. You can sell the home or refinance the loan before the rate resets. People who can reasonably expect a significant salary increase before the reset — such as medical residents or law students — may also benefit, McCoy said.

But the option may be too risky, for example, for employees who see a variable rate loan as the only way to afford a specific home.

“I’m not going to give them an arm,” she said. They could lose the house and much of their investment if they can’t make the higher payments.

Ultimately, it comes down to how comfortable you are with the risk, Seay told Kansas State.

“I have a low tolerance for risk,” he said. “I would never have an ARM.”

Q: Can the interest on an ARM be reset at a lower rate?

A: Yes. After the initial repayment period, ARM rates are based on a benchmark market index and a fixed rate called the margin. Thus, if the index falls, the loan rate may also fall. But many loans have a floor below which the rate cannot go. Ask your lender or review your loan disclosure documents to find out what this rate is.

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