Another important trend to watch is rapidly becoming clear. More Americans are choosing ARMs in order to manage elevated borrowing costs. Nakul Mishra, who purchased a new home in July 2022, went with a 7-year ARM. This choice affords him the ability to have less immediate cash outlay and liquidity in this uncertain economic climate. That’s right—ARMs are back with a vengeance. As of September 2023, they represent 12.9% of all mortgage applications, the highest percentage since the subprime mortgage crisis of 2008.
The increase in ARM popularity indicates a major shift with today’s homebuyers. They are clearly betting big and with confidence on future drops in mortgage rates. The Federal Reserve has lowered its benchmark rate two times this year already, which could have an impact on ARM loan rates. For today’s homeowners like Mishra dealing with rising costs all around, it’s easy to see how ARMs have become attractive.
Understanding Adjustable-Rate Mortgages
Adjustable-rate mortgages are intended to provide borrowers with short-term relief from elevated borrowing costs. Mishra’s loan has a 7-year step rate loan with a fixed introductory period. That’s important because it allows him to benefit from lower payments upfront. Beyond this introductory window, the interest rate will reset every six months, increasing borrowers’ monthly payments over time.
While ARMs can be beneficial, it’s vital that potential borrowers understand the terms of an ARM. And Mishra’s loan can increase by no more than two points. This adjustment will take place at the first renewal after the initial period expires. After an initial period, the interest rate can increase up to 10.5%, alarming many in the financial community.
“The interest rate after the seven-year period can be scary,” – Nakul Mishra
Mishra admits these risks are real, but is largely optimistic about connected technology’s potential over the next few years. If he’s right that mortgage rates will soon fall, it means the decision to choose an ARM will be a smart risk.
A Shift in Market Dynamics
Since 2020, the risk profile of ARMs has changed dramatically. Today, nearly four of every five began ARMs still have fixed periods of five years or more. In fact, two-thirds of them have fixed periods that extend out a minimum of seven years. This new change allows borrowers more predictability. Unlike past adjustable-rate mortgages (ARMs), which often had fixed terms of just one to three years, this change provides a new and more stable alternative.
Another factor to the ARMs revival is the heightened regulation around ARMs. Increased documentation requirements have been imposed. Those with the weakest credit profiles—often minorities and low financed workers—are having greater difficulty obtaining these loans. The regulatory environment now is markedly different than it was pre-2008. At the time, reckless lending standards for adjustable-rate mortgages (ARMs) helped cause the subprime mortgage meltdown.
“People have to understand the cleanest way to use an adjustable-rate mortgage is if you know you’re not going to stay somewhere for more than five to seven years, whatever that initial term is,” – Martin Seay
By choosing ARMs, homebuyers are playing the hand they’ve been dealt by today’s housing market. They make their decisions accordingly depending on their housing development plans and forecasts for interest rates.
Risks and Considerations
As more homebuyers are taking the plunge into ARMs, experts warn that there is an innate uncertainty when it comes to predicting future interest rates. To underscore the unpredictability of rate changes over longer periods, we cite financial expert Martin Seay.
“An economist can’t tell you what is going to happen with interest rates in seven years, so I can’t imagine the average person is going to be able to accurately predict it,” – Martin Seay
For borrowers like Mishra, fluctuating payments can be a massive burden. If interest rates don’t go down as much as anticipated, they might be in deep trouble. Mishra acknowledges this reality, stating, “The worst-case scenario is that rates don’t go lower and we have to get through the seven years.”
Ultimately, whether an ARM is the right choice for a potential homebuyer will depend on the buyer’s individual situation and long-term goals. Andrew Marquis, of Residential Mortgage Services, adds that many buyers intend to relocate in five to seven years. This combination makes an adjustable-rate mortgage (ARM) a particularly attractive option for interim housing.
“It could be that they are only going to be in their house for five to seven years and might move,” – Andrew Marquis