As potential home buyers accelerate their search to purchase a home before rates climb further, there has been a renewed interest in adjustable rate mortgages (ARMs).
During the height of the housing boom in 2006, ARMs accounted for 36% of all mortgages. In 2013, they only comprise 4.5% of all mortgages. But that could change if rising interest rates continue to push potential home buyers back to ARMs, which offer lower monthly payments and lower interest rates.
Adjustable Rate Mortgages vs Fixed Rate Mortgages
Fixed rate mortgages (FRMs) are a type of mortgage loan where the interest rate remains the same for the duration of the loan. An adjustable rate mortgage typically comes with a lower interest rate, but this rate can vary according to market conditions. Because the interest rate on ARMs can vary, they can leave some homeowners paying a much higher monthly payment than they initially anticipated. The riskier nature of ARMs helped cause them to fall out of favor when the economy crashed, especially as rates for FRMs began to fall.
Why ARMs Fell Out of Favor
Prior to the housing crash, rates steadily increased until near the end of 2007. ARMs were popular because they offered potential home buyers the possibility of getting into a home with a lower rate and smaller monthly payments than a FRM. When the financial market crashed in 2008, the Federal Reserve stepped in and instituted its bond buyback program to help push rates down.
Rates continued to fall near historic lows and thus erased much of the incentive that had previously been in place to get an ARM. The fixed rate mortgages on offer were safer and came with low rates that made owning a home much more affordable. However, market conditions have pushed rates back up. Interest rates for a 30 year fixed loan rose nearly a full percentage point since the end of May and now currently sit at 4.46%.
The Comeback of the ARM Loan
Potential home buyers are not just feeling pressure from rising interest rates, but from rising home prices as well. This was the case for Alicia and Ryan Diederichs who are now looking to make a home purchase. Alicia Diederichs says, “I feel like we might get priced out of the market in a few months, and just depending on the mortgage payment whether we could afford it if the interest rates go up more.” She continues, “Ideally we would do a 30 year fixed, but it’s all going to be dependent on the end mortgage payment, what we can afford, so we would have to look at an ARM potentially if rates continue to rise.”
It’s often been said that history repeats itself, and it feels appropriate to wonder whether the market may be returning to conditions which help fuel the housing crash in the first place. Prior to the housing crash, numerous homeowners were unable to keep up with their mortgage payments for their ARMs as their interest rates ballooned out of control. If interest rates are indeed scheduled to rise as many housing analysts expect, this should weigh heavily on the minds of those looking to take out an ARM.
Adjustable rate mortgages are higher risk by nature and should be approached with caution. It’s important to keep in mind that while they may be less expensive now, market conditions may likely push them up far past what the borrower may have expected. If you’re shopping for a home loan, it’s worth weighing the advantages of locking into a 30 year fixed rate while rates are still low.