Adjustable-rate mortgages (ARMs) are back, especially in the higher price brackets around $453,000 and above. And as loan rates climb, as they are expected to do throughout the year, they probably will become more popular.
But wait: Weren’t ARMs responsible, at least in part, for the 2008 housing crash and subsequent mortgage market meltdown? Are homebuyers setting themselves up for another fall?
Well, no, ARMs weren’t responsible for the crash. Actually, the loan product itself is quite sound. After a set number of years, the rate you pay adjusts to market conditions at that time. The rate could go up -- by as much as 2 percentage points a year, usually, to a maximum of 6 points over the life of the loan -- or it could go down.
No, what got borrowers and lenders into trouble wasn’t ARM loans; it was the loose standards underwriting them. At the time, the joke was that if you could fog a mirror, you qualified for a mortgage.
The dicey variations of ARMs, though, were no joke. These included loans in which only interest was collected for a set period; “pay option” ARMs, in which you decided when to pay and how much; and negative amortization ARMs, in which the loan balance actually went up, not down. Some lenders approved these and other loans with little or no documentation to prove borrowers were employed, or that they earned enough to make their payments.
“The underwriting standards used to approve borrowers for those loans by some lenders were abysmal,” says Quicken Loans Chief Economist Bob Walters.
Today’s ARMs, however, are “very different” from the pre-crash versions, according to Archana Pradhan, an economist for analytics firm CoreLogic. According to CoreLogic, 3 out of every 5 ARMs originated in 2007 were either low- or no-documentation loans. In 2005, 3 out of 10 ARM borrowers had credit scores below 640.
Today, says Pradhan, almost all adjustable loans are full-documentation, fully amortizing loans made to borrowers with credit scores above 640. Also pretty much gone are the so-called teaser rates -- rates that started as much as 3 percentage points below the true starting rate -- that were offered to entice borrowers.
Based on the four major underwriting variables -- credit score, loan-to-value ratio, debt-to-income ratio and documentation -- ARMs are of “better quality” than even fixed-rate loans, Pradhan reports. As of last year’s first quarter, for example, the average credit score among ARM borrowers was 765, versus 753 for those taking out fixed-rate loans. And the typical LTV was 67 percent on adjustables, versus 74 percent for fixed loans.
But the real proof of how well these loans are underwritten now is that they are performing admirably. While their borrowers still become seriously delinquent more often than fixed rate borrowers, according to CoreLogic’s figures, the rate at which ARMs become major problem loans is significantly lower than they used to. And the bulk of today’s super-late loans -- those that are 90 or more days overdue -- were originated between 2003 and 2009.
No wonder, then, that borrowers are heeding the new call to ARMs. (Sorry, I just had to.)
Uncle Sam no longer counts the number of adjustable loans and fixed mortgages, but several private sources show how great a comeback ARMs have made recently.
According to the Inside Mortgage Finance trade publication, ARM originations leaped 40.5 percent in last year’s second quarter. And Black Knight, another mortgage information and analytics firm, says that ARMs now represent 9.5 percent of all active loans.
However, the story with ARMs today is a tale of two markets: one below the conforming loan limit of $453,000, and the other above it. The conforming limit is the ceiling placed on the size of the loans Fannie Mae and Freddie Mac can purchase from lenders on the secondary market. Anything above that is considered a “jumbo” loan.
According to the Mortgage Bankers Association, as of October, just 3.2 percent of all conforming loans were ARMs. On the flip side, the ARM share of jumbo loans was over 35 percent (as of December 2013). And more recently, jumbo ARMs have consistently been responsible for a 20- to 25-percent share of the entire mortgage market.
This makes perfect sense to MBA economist Joel Kan, who says higher-end borrowers have the income and credit necessary to “absorb the interest rate risk” that comes with adjustable rate mortgages.
Of course, ARMs are not for everyone. Far from it. “There is never a one-size-fits-all” loan product, says Quicken’s Walters, who uses an ARM on his own residence. “But they are not the villains they are sometimes portrayed to be.”
Because ARMs come with lower starting rates than fixed-rate loans, the ideal candidate is someone who can peg a major life event to the first adjustment period. For example, if you expect to upgrade or downsize within a certain timeframe, or you don’t plan to be in the house you’re buying very long, you should take a serious look at that option.