Why adjustable-rate mortgages are hot again

PHILIPPE HUGUEN/AFP/GETTY IMAGES - When buying a house, it is important to calculate which mortgage is best for you. Many borrowers are considering adjustable-rate mortgages, which fell out of favor during the recession and recovery.

The Washington Post

by Katherine Reynolds Lewis, Published: July 18

When Brian Bartlett bought a one-bedroom condominium in Rosslyn last month, he asked his mortgage broker to price a range of mortgages, from a one-year adjustable rate to a 30-year fixed rate. The seven-year ARM ended up giving him the best rate without picking an uncomfortably short time frame.

“My decision was pretty much to get the lowest rate possible while also managing the risk,” said Bartlett, who is 29 and single. “It was right in the middle, the sweet spot for where I am in my age and my situation. Seven years from now, I’ll probably be in a much different place financially and in my personal life.”

The rate for the mortgage he chose will stay at 3¼ percent for seven years, and then may adjust each year thereafter, based on the Libor rate. But the highest the rate could be is 8¼ percent and the lowest is 1¼ percent. Bartlett put down $350,000 in cash to get the mortgage under the conforming loan limit of $417,000 and obtained an interest rate half a point lower.

Bartlett is one of many borrowers who have considered adjustable-rate mortgages, which fell out of favor during the recession and recovery but were given a second look as the 30-year fixed rate approached 4 percent.

ARMs are considerably less than fixed-rate options. This week, the 30-year fixed rate dropped to 4.37 percent, still far above the 3.17 percent and the 2.66 percent, respectively, for the five-year and one-year adjustables.

In 2006, ARMs made up a quarter of home loan applications. Since September 2008, applications for ARMs have held a market share of only a few percentage points. But in May and June there was steady growth in ARMs to as high as 7.5 percent the week ending June 28, most recently hitting 7.2 percent the week ending July 12, according to the Mortgage Bankers Association.

The recent spike in interest rates, driven by concern about the Federal Reserve Board’s monetary policy intentions, has encouraged some borrowers to find lower rates in the ARM market, where previously they would have been happy with a 15- or 30-year fixed-rate loan, according to analysts and home mortgage experts.

“Given the significant changes in the market over the last few weeks, we’ve seen a significant uptick in the number of people who are considering and taking adjustable-rate mortgages,” said Bob Walters, chief economist at Quicken Loans in Detroit. “For most people, an ARM is a really viable product.”

You may associate ARMs with the housing crisis, because subprime adjustable-rate mortgages were the culprit in many bankruptcies and foreclosures. But the exotic products that got homeowners into trouble were often sold with insufficient or no income documentation. Moreover, the most deadly mortgages were those structured so that borrowers were repaying only interest or, worse, paying less than required to cover the mortgage interest — termed a negative amortization schedule — which left them paying interest upon their interest payments.

“It’s not ARMs that were exploding, it’s that some of the products that were engineered and the payment methodologies did put borrowers at a disadvantage. What we have in the marketplace today are more traditional adjustable-rate products,” said Keith Gumbinger, a vice president at HSH.com, a mortgage information Web site. “The most toxic ARMs have completely vanished from the market.”

Indeed, traditional ARMs ended up helping some borrowers during the recession because as interest rates fell to rock-bottom levels, they adjusted down and lowered the required monthly payment. That’s what happened to Jeff Werner and Claudia Sans when the rate on their one-bedroom co-op near U Street in the District dropped in 2009 after their seven-year ARM expired.

“Historically, a five- or seven-year ARM has performed way better than comparable 30-year mortgages,” said Harris Rosenblatt, a senior mortgage banker with Eagle Bank in Rockville. “An adjustable-rate mortgage has always been a benefit to the consumer if they understand how real estate values work and how the sale of bonds work. Given that understanding, you can build from there and really benefit from ARMs.”

Before you jump into an ARM, it’s important to understand the product and decide whether it meets your needs, based on your personal and professional plans.

“First and foremost, how long do you think you’ll be living in your home? We know from statistics the average American moves every seven to 10 years, ” Walters said. “Most 30-year mortgages don’t last past the 10th year.”

If you’re planning to move — or it’s possible that you’ll move — within the next decade, an ARM could make sense. Look at the rates for the variety of products — most popular are the five- or seven-year ARMs — to see how much money you could save for being willing to take an earlier adjustment.

For Bartlett, the difference between a five-year and seven-year ARM was only about a quarter point, so he went with the latter. But a 30-year fixed-rate mortgage would have raised his rate a full point or more.

ARMs can make more sense for borrowers in the jumbo market, where rates are higher and the difference between an ARM and a fixed-rate loan can mean tens of thousands of dollars, Gumbinger said.

Communications professional Bill McQuillen refinanced from a 30-year fixed mortgage to a seven-year ARM last month to lower his rate from 3.875 percent to 2.5 percent. Once the seven years expire, the most his rate can reach is 7.5 percent, but it would take an extended period of high rates for that to happen.

“I’m not getting thrown under a bus if this goes up,” McQuillen said. “I don’t plan to reduce my monthly payment. I plan to keep that the same, which means more money is going straight to principal.”

The next question to ask is how the product works. After the initial period of the ARM passes, does the rate adjust based on the Prime rate? Or the Libor? What is the margin or spread to that reference interest rate that will determine your interest rate?

Make sure you understand the terms of the rate adjustment, and look at some scenarios so you’ll know how high your monthly payment could be if interest rates hit the roof.

“What’s the worst thing that could happen? It’s always the most important question to ask,” Rosenblatt said.

Werner and Sans never expected to be in their home — which Werner bought before they were married — for more than seven years. “I bought it when I was 34 and never thought I’d be married and in a one-bedroom apartment when I turned 40,” he said. Shortly after the rate began to adjust, they bought a larger co-op in the same building at a 30-year fixed rate.

If you are using an ARM to lower the payments to an affordable level, that’s a red flag that you may be making a financially irresponsible move. If the housing crisis taught us anything, it’s that you can’t count on home prices appreciating or the market being hot when you need to sell.

“I do not believe that the adjustable rate should be the key factor in purchasing the property. If you need the adjustable rate to qualify, buy a cheaper house,” said Carl Mazzan, a mortgage loan officer in Northern Virginia who has seen a dramatic increase in demand for ARMs recently. “Consider the adjustable as a way to save money during your time in the property.”

Mazzan noted that the increase in demand for ARMs has been in the midterm ARMs, with five- or seven-year terms, not the one-year or six-month ARMs that were popular during the housing boom. “ I have not done one of those in seven years.”

Bear in mind that although rates have recently ticked upward, they are still very low by historical standards. It’s more likely that in five or 10 years, rates will be higher than they are now. So if you are counting on refinancing at that point, an ARM might not be right for you.

“It’s an open question as to why anyone would be interested in ARMs when short-term interest rates are so low,” Gumbinger said. “There’s only one place they’re likely to go in the future.”

On the other hand, if you are five years from retirement and planning to downsize, or a young couple buying a small home but expecting to expand in three years, you could responsibly choose an ARM that fits your expected time frame. It never hurts to overestimate the time you’ll be in the house in case your plans change or you have trouble selling your home in the future.

“For the astute buyer who’s working with a good loan officer who’s willing to ask the right questions, an ARM can save you a substantial amount of money during your time in the property,” Mazzan said.