With house prices and mortgage rates continuing to rise, many potential borrowers need to be more creative when looking for home loans. Today, we’ll explore one solution in the form of adjustable rate mortgages.
What Is An Adjustable-Rate Mortgage?
With an adjustable-rate mortgage (ARM), there’s an often attractive initial interest rate which is fixed for a period of time. This fixed period runs anywhere from 3 to 10 years. An ARM 3/1 locks you in for the first 3 years where an ARM 10/1 gives you a longer run of 10 years at the fixed rate. You can also opt for an ARM 5/1 or an ARM 7/1.
After this point, as the adjustable-rate mortgage’s name suggests, the rate could go up or down or it might not change at all. Adjustments are made based on a commonly used interest rate index like LIBOR. Since those future interest rates are uncertain, adjustable-rate mortgages have always been considered a risky proposition. Before we glimpse at why adjustable-rate mortgages are on the rise, how did they get such a bad rep?
What Went Wrong With Adjustable-Rate Mortgages?
According to the New York Federal Reserve, in 2005 adjustable-rate mortgages made up almost 40% of total mortgage market share. At that time, before the global housing crisis, fixed-rate mortgages averaged out at 6.27%.
When the subprime mortgage market imploded in 2006, the ensuing housing crisis spiraled and pushed the US economy to the very edge of recession. People with subprime 2-year ARMs hoping to sell or refinance before the fixed period was up found that simply didn’t happen.
It was those 1/1 and 2/1 ARMs that had no caps whatsoever on interest rates being jacked up along with heavy prepayment penalties. With borrowers allowed to make payments that didn’t even cover interest, the economic meltdown was triggered at least in part by these questionable features of adjustable-rate mortgages, something that bitterly tainted the image of ARMS.
Fast forward to 2012, and you could pick up a fixed rate mortgage for just 3.3% meaning a 2.74% ARM just didn’t make an attractive alternative for such a miserly spread of 0.56%, especially with the memory of that housing crisis still fairly fresh.
Today, though, interest rates are nothing like they were in 2012 which leads us in part to the reason why adjustable-rate mortgages are on the upswing in 2018.
Why Are More People Considering Adjustable-Rate Mortgages?
In January of 2018, adjustable-rate mortgages had increased their market share to 5% jump up to 6.7% by March. Freddie Mac’s most recent survey shows 30-year fixed rate mortgages average 4.2% while a 5/1 ARM will run you 3.3% and this widens the spread considerably to almost a single percentage point.
If you don’t want to buy down your interest rate with discount points, the only other way you’ll get rates like 2012 is to roll with a 5-year adjustable-rate mortgage. So it’s only natural that ARMs become more popular when the fixed rate alternative is much more expensive, and house prices are on the rise.
Are Adjustable-Rate Mortgages in 2018 Safe?
Given the past adjustable-rate mortgages, it’s only natural to question whether it’s a wise move to consider an ARM at all. The good news is that the majority of the riskiest elements have been stripped away from adjustable-rate mortgages. Ruthless prepayment penalties are history. You won’t find loans based on unrealistically low rates either. Rate increases are also capped meaning you’re in a far less volatile position than those seeking ARMS before the housing crisis.
If you go for a 5/1 ARM mortgage today, you’ll get that 3.3% rate locked in for 5 years after which point the rate can be adjusted once a year. One other point that’s often overlooked with ARMs is that the rate doesn’t necessarily go up. Over recent years, many borrowers have found their adjustable rate has dropped.
As long as you’re aware of the degree of uncertainty, adjustable-rate home loans are undoubtedly worth considering today. With most of the drawbacks no longer in place and an attractive spread, an ARM is not the ticking time bomb it used to be.
Now we’ve highlighted some of the specific reasons for the increased popularity of ARMs in 2018; we’ll round out with a breakdown of when it pays to think about an adjustable rate loan.
When Adjustable Rate Mortgages Make Sense
- You don’t plan to stay in the property long. If you’re pretty convinced you’ll have offloaded the property after 3 or 4 years, an ARM is worthwhile.
- The mortgage rate is high. If interest rates are higher when you’re looking to buy, you’re far less likely to be hit with a severe hike when it’s time for adjustment.
- Your credit rating is likely to improve. Since mortgage rates can vary sharply according to your credit history, if you think your rating will improve by the time the fixed rate is up, it might be worthwhile hedging your bets by thinking about an ARM.
Make An Appointment With Your Mortgage Broker
If you’re seriously thinking about an adjustable rate mortgage, speak with your mortgage broker to confirm the spread and investigate your various options.