More and more borrowers are using variable rate mortgages. Are they in trouble?

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Adjustable rate mortgages, or ARMs, were a popular way to finance homes in the 1990s and 2000s, but their popularity waned after the 2008-09 financial crisis. Not only were banks not as willing to make these “riskier” loans, but with fixed rate mortgages at or near generational lows since then, they weren’t as necessary to keep mortgage payments at a affordable price.

Now, with mortgage rates rising and house prices soaring, ARMs are starting to make a comeback. In the first half of 2022, ARMs grew from 3% of all mortgages to 10%, more than tripling in popularity.

The exact numbers vary constantly and depend on the mortgage lender you are considering, but as I write this one popular lender is offering 30 year fixed rate mortgages with a 5.75% interest rate for borrowers qualified, and has a Rate of 4.5% indicated for a 5/1 arm. On a $400,000 loan, this is the difference between a monthly principal and interest payment of $2,334 and a payment of $2,027. With numbers like this, it’s no surprise that more and more borrowers are turning to ARMs to help them afford to buy homes.

Should we be worried?

You may recall that adjustable rate mortgages played a significant role in the mortgage meltdown of the late 2000s that led to the Great Recession. But it is important to realize that these are not the same loans that were widely used back then. There are a few differences:

  • ARMs used in the 2000s were often given without a down payment. In fact, some lenders have even made loans for After than the purchase price of the home and let the borrower start the term of the loan underwater.
  • Borrowers could get an ARM with little or no credit, income, or assets. These were infamously known as NINJA loans (no income, no job or assets).
  • Many MRAs have been granted with exotic loan terms, such as interest-only repayment.
  • There was often no cap on how quickly the mortgage rate could adjust. It was not uncommon for borrowers’ payments to double or more overnight.

Today, MRAs are much safer. They have the same (or stricter) credit standards as their fixed-rate counterparts, and to prevent borrowers from being caught off guard by massive increases in monthly payments, they usually have a cap that governs how quickly their rates can increase at the same time. In short, although ARMs are not suitable for all borrowers, they do not pose the systemic risk that they did before the financial crisis.

Is an adjustable rate mortgage right for you?

While this generation of variable rate mortgages is a far cry from the predatory lending practices of a few decades ago, that doesn’t mean they’re right for everyone.

MRAs are most appropriate for homebuyers who:

  • Do not expect to be in their home for more than a few years. In other words, if you plan to sell the home before the initial rate period expires, you don’t have to worry about your monthly payment increasing.
  • Expect to be able to refinance advantageously before the expiration of the initial rate period. No one can predict where interest rates will be in five or seven years, but as an example, maybe you’re building credit and only have an average FICO score. If you can refinance in five years with prime credit, using an ARM now might be a good decision.

If you’re using an ARM to buy a home, it’s important to be fully aware of the downsides – in particular how often your rate may be adjusted, how the new rate will be calculated, and how much your rate (and monthly payment) could increase to any time.

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