Adjustable-rate mortgages: Are they worth it?
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," says 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 importantly, 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," says A.W. Pickel, president of Waterstone Mortgage in Pewaukee, Wisconsin. "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," says Claudia Mobilia, senior vice president of operations for Embrace Home Loans in Middletown, Rhode Island. "You don't see that anymore."
The ARMs of the past also included a prepayment penalty that discouraged borrowers from refinancing, says Shawn Sidhu, a mortgage consultant for C2 Financial in San Jose.
"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 says. "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 says. "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."
How ARMS work:
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 says. "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:
• Index: The index, chosen by the lender, is the benchmark rate to which the loan is tied.
"Most lenders use the one-month LIBOR index [the rate banks charge one other on the international market]," Pickel says.
• Margin: The margin is the fixed amount above the index that a mortgage rate can adjust, which is set by the lender based on a borrower's credit profile. If the margin is 1.5 percent, the mortgage rate would be 4 percent when the LIBOR index is 2.5 percent.
The rate won't change during the fixed period, but if the LIBOR rate increases when the rate is due to adjust, the rate could go up. If the LIBOR rate, which started at 2.5 percent, goes up to 3.5 percent and the margin is 1.5 percent, the mortgage rate would adjust to 5 percent from 4 percent after the fixed time period expires.
• Caps: A big protection in place with today's ARMs is a cap. Lenders must tell the borrower the maximum amount the loan can adjust at the first reset and at subsequent resets and a maximum possible adjustment. A typical ARM has a 2/2/5 cap, meaning that the rate can rise by up to 2 percent initially and then by no more than 2 percent at each adjustment up to a maximum of 5 percent above the initial rate.
If the mortgage rate on a 7/1 loan is 4 percent during the first seven years, the rate in the eighth year could go as high as 6 percent but no higher. In the ninth year, it could go up to 8 percent but no higher, and it could never go above 9 percent.
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%, a 5/1 ARM rate at 3.96%, a 7/1 ARM rate at 4% and a 10/1 rate at 4.18%.
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 says.
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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 says.
"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 says.
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 says. "Typically, lenders want at least a 10% 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 says.
"If you plan to move or refinance within a few years, then an ARM could be right for you," he says. "The sweet spot for most ARMs seems to be seven years, which is not too short but gets you a lower rate."
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When to consider an ARM:
• You plan to keep the house for a short time: If you know you'll move before the loan resets, you can take advantage of the lower interest rate and lower payments.
• You're selling another house: If you're selling another property, an ARM can keep your payments on your new home low until your previous home sells. Once it does, you may be able to make a substantial payment on the balance of the ARM so your payments are lower when the loan resets, Mobilia says.
• You expect an increase in your income or an inheritance: "In the Bay Area, a lot of people in the high-tech industry get lumps of cash as bonuses and they have the flexibility to pay down their loan faster," Thompson says. "When the loan resets, their balance could be much lower."
• You're buying in a high-cost housing market: "In San Francisco, even a starter home can cost $700,000," Thompson says. "If you can pay a rate that's 0.625 percent lower than the fixed rate, you could save $20,000 over seven years in interest payments. That's $40,000 on a $1.4 million property."
• You're planning for retirement: If you plan to pay off your mortgage during the fixed period of your ARM so you can retire or move, an ARM can help you reach your goal faster because you're paying less in interest, Thompson says.
An ARM is not a good fit for borrowers who are risk-averse, Thompson says, 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 agrees.
"I don't recommend ARMs for first-time buyers because they may not understand the risks," Mobilia says. "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, Maryland, says 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 says, 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 says, a fixed-rate loan makes more sense.
The important thing to remember, Thompson says, is 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.