ORANGE COUNTY, Calif. — When buying a home these days, it may cost you an arm and a leg, but some are opting for an arm.
ARM or adjustable-rate mortgage loans, once believed as one of the contributing factors that led to the Great Recession of 2008, are coming back. Real estate agents and mortgage brokers say the loan program is different this time around.
With mortgage rates rising — and rates expected to continue to increase — real estate agents see more and more home buyers looking into and using the ARM financing option instead of the traditional 30-year fixed rate.
"The majority of my clients have been using ARMs," said Abby Ronquillo, founder of NetRealty in Corona. "It's their way to combat the high-interest rates."
Unlike a traditional 15- or 30-year mortgage with a set-in-stone fixed rate, an ARM is a mortgage option that allows a borrower to lock in at a lower interest rate (lower than a fixed rate) for some years before it adjusts.
Most adjustable-rate mortgage options offer five, seven, or ten years. Once the ARM rate changes, the borrower's rate and payment usually go higher or lower depending on the state of the economy. For example, a borrower with a 7/1 ARM would have a fixed rate — or lower payment — for the first seven years before the rate switches.
"It's a fine option for the right person and in the right situation," said Jeff Lazerson, the president of Mortgage Grader in Laguna Niguel. "It's so important to realize that lower interest payments can knock down the payment, especially in the jumbo market. There's nothing wrong with them, but you have to understand that you don't know what the rate is going to be at the end of the locked-in period."
According to the Mortgage Bankers Association, the number of applications to use an ARM loan to purchase a home in California was 11.1% in February 2022. The number of applications for ARMs rose 6.2% in California year-over-year, the highest in the country. Nationally, total applications for ARMs increased to 6.6% week-to-week ending March 25.
As of April 5, the national average 30-year fixed mortgage is 4.8%. The average 10/1 ARM rate was 3.9%, according to Bankrate.
ARMs have received a bad reputation as one of the reasons for the mortgage meltdown and the Great Recession of 2008.
In a study by the Brookings Institute, the authors blamed the rapid rise of lending to subprime borrowers (borrowers who typically would not have been approved for a loan) and the introduction of short-term ARM products as one of the origins of the financial crisis.
The authors said lenders were handing out two or three-year ARM products with low initial payments that borrowers can refinance out of once the rate matures.
"These so-called 'teaser' interest rates were often not that low, but low enough to allow the mortgage to go through," wrote Martin Neil Baily, Robert E. Litan, and Matthew S. Johnson. "Borrowers were told that in two or three years the price of their house would have increased enough to allow them to refinance the loan. Home prices were rising at 10% to 20% a year in many locations, so that as long as this continued, a loan to value ratio of 100% would decline to 80% or so after a short time, and the household could refinance with a conformable or prime jumbo mortgage on more favorable terms."
The problem is the housing bubble popped. Mortgage payments ballooned when the economy tanked, and many borrowers couldn't pay their new adjusted mortgage or refinance their way out of it. This led to a wave of home foreclosures.
From 2004 to 2006, the ARM share was around 30% of home loan purchases. The traditional fixed-rate mortgage rate was about 6% during that time, said Joel Kan, the associate vice president of Economic and Industry Forecasting at the Mortgage Bankers Association in an email to Spectrum News.
"That was also when mortgage supply was at historical highs and underwriting much looser and there were riskier ARM products," said Kan. "Following the Great Recession from 2008 to 2010, policy has been much tighter (Dodd-Frank) and underwriting standards more stringent, and borrowers have had stronger credit profiles."
Kan added that in the past 10 years, "we have seen a shift toward ARM loans with longer fixed-rate periods, i.e. a shift away from 3/1 and 5/1 ARMs to a majority 7/1 and 10/1 ARMs, based on our applications data."
Sheila Nufable, a community lending officer at Bank of America Pasadena, said she doesn't advise ARM loans for first-time homebuyers.
"Many of my clients are focusing on getting a fixed rate for the long-term," said Nufable. "They don't want to take that risk. They are being careful because the market is so volatile. They can't predict what it will be five, seven, or 10 years from now."
Nufable said ARM loans are generally for investors or those people that don't plan to stay in their homes for the long haul.
"They hope they can sell the property before the rate matures," said Nufable. "It's a good product for investment homes or a second home. The ARMs are for the more risky buyers."
For Ronquillo, her clients with ARM loans are banking on lower payments during the introductory period and refinancing out of it before the rate matures. She said qualifying for an ARM loan has become more stringent and requires higher credit, FICO scores, and healthy cash reserves. She also added that the typical homeowner would refinance every four to seven years, anyway.
"Many of my clients understand the big picture - rates go up and down," said Ronquillo, adding that one client saves $1,000 every month with a 7/1 ARM loan instead of a 30-year fix. "ARM loans are for the very well qualified. Before it was only stated income to get an ARM loan. That's why people got in trouble."
Lazerson noted that whether a borrower chooses a traditional fixed rate loan or ARM loan, with interest rates rising and inflation high, people should be conservative with their money.
"The key is to be conservative," said Lazerson. "Don't overextend yourself, especially with ARMs. If you don't have much money left over every month. If you're stretching your budget. Don't do it. Don't max yourself out. And if you're not going to be conservative, make sure you have an exit plan."