Adjustable Rate Mortgages Make Slow Comeback

The toxic mortgages of the Recession – adjustable rate mortgages – are slowly regaining popularity with investors and currently finance 7 percent of new home purchases, reports the 27th Annual ARM Survey by FreddieMac.

At their peak in 2004 ARMS accounted for 40 percent of mortgages, but by early 2009 their share fell to 3 percent, said Frank Hothaft, chief economist at Freddie Mac, who predicts the ARMS will make up 9 percent of mortgages issued in 2011.

“We are expecting ARMS to gradually gain back some favor with mortgage borrowers,” Hothaft said. Current ow interest rates are increasing the appeal of the products, which offer initial rates below those on fixed-rate loans. The terms and conditions of ARMS vary greatly, but one of the most popular ARMS – the 5/1 hybrid ARM – locks in the initial rate for five years, then adjusts it every year. In early January 2011, the difference in interest rates between an average 30-year fixed-rate loan and the 5/1 hybrid ARM was 1 percent, the Freddie Mac report said.

ARMS are particularly appealing for buyers who plan to sell their home before the initial period expires and avoid rate adjustments, which are typically tied to short-term Treasury rates plus a margin, or markup, charged by the lender.

The Mortgage Bankers Association has also measured increased use of ARMS and finds they accounted for 5 percent of mortgages in the fourth quarter of 2010 and 6 percent in the first quarter of 2011. The MBA predicts they will account for 7 percent of mortgages through 2012.

ARMS earned their bad reputation during the Recession when the loans proved much more likely to turn toxic than conventional fixed-rate loans. According to Amy Crews Cutts, deputy chief economist at FreddieMac., borrowers who took out ARMs during the peak years of the housing boom – 2005 through 2007 – saw their monthly payments soar by as much as 165 percent within a few years. As payments increased, equity fell with the housing market, and by the fourth quarter of 2009 more than 42 percent of subprime ARMS and 19 percent prime ARMS were seriously delinquent. Overall, delinquency rates for fixed-rate mortgages stood at 8.1 percent.

Fixed-rate mortgages remain, by far, the preferred loan for borrowers who want the security of a fixed monthly payment. Studies show that housing prices are most stable in neighborhoods where most homes are financed with fixed-rate mortgages, Cutts said.
States with the biggest drop in home values were also states where relatively few borrowers had fixed-rate loans. Only 51 percent of the loans in Nevada were long-term fixed-rated mortgages, and home prices had fallen 52 percent in the Silver State by the second quarter of 2010, said Cutts. In contrast, home prices slipped less than 2 percent in South Dakota, where 85 percent of mortgages were fixed-rate mortgages.

“The long-term fixed-rate mortgage is working as an economic shock absorber,” Cutts said, “insulating families from payment shocks, protecting mortgage investors from the highest delinquency rates and providing a welcome measure of stability to America’s home prices and communities.”

ARMS provide initial savings, but homeowners can run into trouble when rates rise above their ability to pay. The risks of ARMS were heightened by the Recession because many homeowners faced a loss or decline in wages and home values at the same time their monthly payments increased.

ARMs can actually cost borrowers more over the long-term, the Federal Reserve warns in a consumer handbook, so it’s important for investors to understand the terms and conditions of individual products. The length of the initial rate period can vary, as well as the index underlying the rate adjustments. The longer the initial period, the higher the initial rate tends to be. Payments can also be affected by caps and limits on how high and how low the rate can go. Borrowers need to understand how high their monthly payment could go, and should be confident they will be able to afford rising housing costs.