ARMs Decline in Popularity: Is it Time to Switch to Fixed-Rate?
Compared to only a few years ago, Adjustable Rate Mortgages (ARMs) have fallen almost completely out of favor. According to a recent report, “In 2005, when the housing bubble was peaking, ARMs constituted more than one-third of all mortgage applications…By 2007, ARM applications had dropped to 15 percent and, in recent weeks, ARM applications constituted less than 2 percent of all mortgage applications nationwide.”
In other words, both banks and homebuyers are increasingly unwilling to assume the risks associated with a mortgage product that has been connected with notorious uncertainty and even “failure.” Among prime borrowers, the difference in the delinquency rate for one state between fixed-rate and adjustable-rate borrowers is over 5%, such that prime ARM borrowers are 3 times as likely to become delinquent. The sub prime numbers are even more grim: “Nationally, 48 percent of subprime ARM loans were at least one payment past due.”
Gone are glory days for the “pay option ARM,” the “interest-only ARM,” and the ever popular “hybrid ARM,” all of which rely on tantalizingly low initial rates (and low interest payments) to attract borrowers. The problem with these loans is that they assume that benchmark rates would remain low, while home prices would remain high. In hindsight, both of these assumptions were erroneous- though it is worth noting short-term rates have come down slightly over the past year after exploding in 2007.
[In industry parlance, the initial rate is known as the teaser rate. After a certain period of time, the interest rate is permitted to fluctuate (based on a spread to an interest rate index), but it is usually restricted by a periodic cap and lifetime cap, both of which are designed to prevent rates from rising (or falling) dramatically]. Some unscrupulous banks sold ARMs with very high caps, which resulted in a skyrocketing interest rate and monthly payment after the teaser rate expired.
Another questionable assumption was that borrowers could refinance at a comparatively low, fixed-rate as soon as their adjustable rate began to rise. For example, with a 5/1 hybrid ARM, as long as you successfully refinance within five years (at which point the interest rate switches from fixed to floating), you are theoretically protected from the inevitable rate hike. However, borrowers with declining home prices (the vast majority) are now learning that this is far from easy.
For those of you with ARMs that haven’t yet reset, it might be advisable to look into refinancing. While rates are currently low – the average adjustable rate is 4.69% for one year and 4.82% for five year, it’s any one’s guess as to how long they will stay low. If rates do climb, you will find yourself facing a “payment shock,” especially if the caps on your interest rate aren’t favorable. With 30-year fixed rate currently around the same level as adjustable rates, why take the chance? The only real exceptions are borrowers who plan to sell their house before the interest rate resets and those seeking nonconforming loans- i.e. for mortgages greater than 417,000.