It’s no secret that mortgage rates have been rising. Over the past 15 months, the interest rates on 30-year fixed-rate mortgages have jumped nearly a full percent, increasing from 3.81% in November 2016 to 4.69% this March.
And though rates on adjustable-rate mortgages (ARMs) have increased, too, they’re still a far cry from those of longer-term, fixed mortgages. In fact, as of the most recent weekly survey from the Mortgage Bankers Association, the average rate on a 30-year loan was 4.71%. On a five-year ARM? It was 3.98%.
In just the first year, that incremental rate difference could save a buyer about $1,500 on a $200,000-priced home. Considering 37% of metros are currently overvalued, according to CoreLogic, that could be a game-changer for many of today’s buyers.
The Rise of ARMS
Historically, adjustable rate mortgages haven’t been too popular, accounting for only about 4% of all loans at the end of 2016.
But according to the most recent Origination Insight Report from Ellie Mae, it seems that may be changing. This March, ARMs accounted for 6.3% of all mortgage loan originations—their highest share since October 2014.
Rising interest rates on fixed loans are the biggest reason ARM originations are rising. Because ARMs typically offer a lower initial rate up front than fixed-rate mortgages (FRMs), they’re able to save buyers hundreds or even thousands of dollars on their purchase.
Danielle Hale, chief economist at Realtor.com, explained: “As interest rates—including mortgage rates—trend upward, the gap between ARM rates and FRM rates tends to increase, thus buyers can see bigger savings in the initial payment from choosing an ARM as opposed to a FRM.”
Joe Tyrrell, executive vice president of corporate strategy at Ellie Mae, said tight inventory has also been driving ARM demand upward for some time.
“We’ve seen a pretty slow, yet steady increase in ARMs since November of 2015, as there has been a lack of affordable housing inventory and a steady appreciation of home prices,” Tyrrell said.
ARM usage is likely to grow, too—especially with the Federal Reserve expected to raise rates two more times this year. According to Chris Lewis, manager of sales and operations at Angel Oak Home Loans, we can expect higher ARM usage for the foreseeable future—particularly from buyers with higher-priced home purchases.
“Based on a rising interest rate environment, ARM financing is a tool that we anticipate becoming more prevalent in the upcoming months and years,” Lewis said. “So far, we have noticed more ARM loans being originated in the jumbo market—loan amounts above the conforming limits—but we do foresee ARM loans being increasingly attractive to more buyers regardless of loan amount as we move forward into 2018 and beyond.”
Who’s Using ARMs?
There are certain segments of home buyers that lean toward ARMs more than others, and according to Rick Bechtel, head of U.S. mortgage banking at T.D. Bank, first-timers are among the most common.
“First-time homebuyers or those who are on the edge of approval tend to gravitate toward ARMs primarily because the lower rate allows them to purchase more home or to purchase in a hot market, such as NYC or San Francisco,” Bechtel said.
ARMs are especially helpful in metros where demand is high or inventory is particularly low, Bechtel said.
“In hot markets, where simply entering the market is daunting, some buyers need the price flexibility that an ARM offers due to the lower rate,” Bechtel said. “And in a low-inventory first-time buyer market, the same is holding true. In order to get into a home, buyers are selecting ARMs.”
Palmer Heenan, executive vice president of secondary marketing at Flagstar Bank, said his company has seen a rise in ARMs from in-demand markets across California, in particular.
“In high-priced markets like California we’ve seen an uptick in 2018 over 2017, especially in jumbo loans,” Heenan said. “We’re in an environment of rising interest rates and a tight housing supply, and that tends to push housing affordability and demand for ARMs higher.”
Are ARMs a Good Choice?
ARMs can certainly save buyers cash up front, but they’re not the right choice for everyone. Though the loans do offer a lower rate—and a lower mortgage payment—at the outset, it’s important buyers realize those savings are only temporary.
Generally, ARMs come with a fixed-rate period of anywhere from five to 15 years, meaning the interest rate will remain stable for that amount of time. But after that? The interest rate can adjust—going up or down as the market fluctuates. For this reason, most experts recommend ARMs for only short-term buyers.
“Adjustable rate mortgages can be a great tool for the right buyer,” said David Edmondson, senior loan officer at Flagstar Bank. “I’d particularly recommend ARMs to clients who plan to be in their house for a short period of time.”
Still, even with a plan to sell a few years down the line, short-term buyers aren’t completely safe from an ARM’s rate hikes. Ric Edelman, chairman and cofounder of Edelman Financial Services, said there’s yet another risk to worry about: not being able to sell the home.
“If, in fact, rates do rise over that period of time, that means that buyers will have greater difficulty qualifying for a mortgage,” Edelman said.
Who Shouldn’t Use an ARM
According to Edmondson, there are some buyers who should steer clear from the get-go — particularly those on the hunt for their “forever” home.
“The last thing my clients want to worry about after buying or building their dream home is a mortgage payment that adjusts,” Edmondson said. “A 15- or 30-year fixed-rate mortgage provides long-term predictability and stability.”
Edelman agreed, warning buyers: “If you are highly confident you're planning to stay in that house for a long period, you should not choose an adjustable-rate mortgage.”
ARMs aren’t great for investors or vacation home buyers either, Edmondson said.
“Investors like certainty and predictability when it comes to mortgage payments,”Edmondson said. “My investor clients often don’t know how long they’ll keep a particular property. A fixed-rate mortgage helps them predict long-term rates of return much more accurately than an adjustable-rate mortgage.”
Vacation homes are another form of investment, Edmondson said, and more buyers plan to keep them for the long haul. This makes ARMs a poor choice in their case as well.
Taking out an ARM Safely
For buyers seriously considering an ARM product, due diligence is crucial. According to Edmondson, they need to get a full breakdown of the loan’s details from their lender.
“What is the fixed term of the loan? Buyers need to know how long their rate will be fixed,” Edmondson said. “This will allow them to make long-term plans on when to refinance into a fixed-rate or move on from the home.”
He also recommends buyers ask about pre-payment penalties and rate caps.
“Adjustable-rate mortgages all have an initial cap, which is how much the rate can go up or down after the fixed portion of the loan expires; an annual cap, which is how much the rate can go up or down annually thereafter; and a lifetime cap, or how much the rate can go up or down over the life of the loan,” Edmondson said. “Understanding rate caps will allow buyers to better calculate the risk they are taking.”
At the end of the day, evaluating those risks—ideally before there’s a contract and the clock is ticking—is what can make ARMs a safe financial choice for many buyers.
“For most buyers, choosing a fixed, 30-year mortgage feels like a safer approach, and while there is some risk to obtaining an ARM with a fluctuating rate, there are protections in place to ensure the rate never goes too low or too high,” Bechtel said. “Especially for first-time buyers who only plan to be in their home for a short period of time, an ARM is a smart way to reduce their interest rate while maintaining a monthly payment that fits their budget.”
