Adjustable Rate (ARM) Mortgages Have Been Shunned For Years — But Should Be Considered In 2018
During the last few years, few mortgage borrowers have bothered with adjustable rate mortgages (ARMs). According to analysts at Ellie Mae, market share for the ARM mortgage is about four percent of all mortgages sold.
That’s not really surprising. After all, when you can get a 30-year fixed mortgage at about 3.3 percent, as you could in 2012, why take on the risk of an ARM mortgage during the same time — at 2.74 percent?
That’s a difference, or “spread,” of .56 percent.
Consider also that this was not long after the housing crisis, when homeowners learned they couldn’t count on being able to sell their houses within a few years of buying. That is, while the low, introductory rate for the ARM mortgage was still in effect.
Part of the Great Recession was triggered by people with 2-year sub-prime ARMs who had counted on selling or refinancing — before the reasonable fixed rate period ended and the really ugly adjustable period began. That didn’t happen, and the memory of the result has remained clear.
That Was Then, This Is Now
Today’s ARM mortgage is different. Some of the riskiest features — prepayment penalties that keep borrowers locked into loans with expensive terms — are gone.
Loans that qualify applicants based on artificially-low rates are no longer allowed. And the most popular ARM mortgage — the hybrid with introductory rates that can be fixed for three to ten years — is backstopped with caps in rate increases and lifetime limits to keep loans affordable.
Borrowers can choose from 3/1, 5/1, 7/1 and 10/1 ARMs. They offer lower interest rates and some measure of safety as well.
The “Spread” Today
The most recent Freddie Mac Primary Mortgage Market Survey showed that 30-year fixed rates are averaging 4.2 percent. Meanwhile 5/1 ARM rates are at 3.33 percent. The spread has widened considerably since 2012, to .87 percent — nearly a full percentage point.
In fact, if you want the same interest rate today that you could have obtained in 2012, there are just two ways to get it.
Okay, there are three. But only two that don’t involve the higher payments of a 15-year mortgage.
2012 Rates: The Expensive Way
First, you can pay about six discount points. Discount points are extra fees you can choose to pay to get a lower interest rate. In the mortgage business, that’s called “buying down” your interest rate.
One point normally lowers a 30-year interest rate between .125 and .25 percent. However, the rate reduction you get with discount points is not consistent. The more points you pay, the less interest rate reduction you get for your money. This is called “diminishing returns,” and it’s not a good thing.
For a $300,000 mortgage, getting from 4.2 percent to 3.33 percent could cost you $18,000 to $24,000. Most people have better things to do with $18,000.
2018 Rates: The Smarter Way
The other way to secure that 3.33 interest rate is to choose a 5/1 ARM mortgage. That gets you the good old 2012 interest rate, without selling everything you own on eBay to pay your discount points.
Your rate is fixed at its introductory rate — in this example, 3.33 percent. After five years, your rate can reset once a year.
The new rate depends on several factors — the index on which your rate is based, the margin the bank adds to your index, and your loan caps. So if your loan caps limit your increase to two percent, the highest rate you can get in Year 6 is 5.33 percent.
If your loan’s lifetime limit is five percent over your start rate, your interest rate can never exceed 8.33 percent.
Keep in mind that ARMs don’t always go up. Many of those with ARMs in the last few years actually saw their rates drop to less than their start rates when they began adjusting.
Which ARM Should You Choose?
That depends on the length of time you expect to keep your home and your mortgage. It also depends on your tolerance for risk.
If you’re establishing yourself in a career, if you’re single and / or childless, or if you just have a short attention span, an ARM with the lowest rate — the 3/1 or 5/1 — probably makes a lot of sense. You’ll save a lot of money in interest while you own your home, and you’re likely to be long gone by the time the loan begins adjusting.
If your idea of big risk is biting into a truffle without asking what flavor it is, you probably want a longer fixed period. If you’ve got a five-year plan, for instance, a 7/1 ARM might help you sleep a little better at night. Understand, though, that the longer the fixed period for your ARM, the higher the interest rate.
You’re likely to see a larger spread between fixed and ARM mortgages when you look for jumbo, aka “non-conforming” financing. This makes ARM mortgages a lot more attractive to homebuyers with larger loans.
In addition, a small difference in interest rate means a lot more to your bank account when the loan is larger.
For this reason, ARMs are much more popular in the jumbo mortgage market — according to Black Knight, the ARM market share is currently double that of conforming loans, and the financial services company predicts this will rise significantly in 2018.
What Are Today’s ARM Mortgage Rates?
The reason to choose (or not choose) an ARM mortgage depends a great deal on the “spread” between the ARM and fixed home loan rates that apply to you. Lender policies differ, so it’s important to get quotes from several competing lenders for both an ARM mortgage and a fixed loan before you choose your next mortgage.