In 2021, more than 90% of borrowers who closed a loan with fintech mortgage lender Neat Loans opted for a 30-year fixed-rate mortgage. But this year, as rates have crested 6%, about 70% of Neat’s originations are adjustable-rate mortgages, a product that until recently had fallen out of favor due to the role they played in the housing crash of 2008 and a decade-plus of fixed-rate mortgages under 5%.
“It’s obviously not just a flip flop, it’s a pretty big move,” said Luke Johnson, the founder and CEO of Neat Loans.
In a tight housing market with a shortage of inventory and soaring rates, many homebuyers are opting for ARMs, which carry lower rates for an initial period of fixed interest and amortize over a 30-year term.
“ARMs can be a good option for someone who’s looking to get into a home, get a lower monthly payment, and gain some equity and then decide if they want to stay in the home or refinance a loan before that fixed period expires” Joel Kan, associate vice president of economic and industry forecasting at the Mortgage Bankers Association (MBA), told HousingWire.
The way ARMs work is lenders offer lower mortgage rates for the initial three, five, seven years. After that initial period ends, rates adjust periodically based on a benchmark or index, such as the Secured Overnight Financing Rate, known as SOFR, based on actual transactions in the Treasury repurchase market.
Application volume for ARMs hit a 14-year high in May, taking up nearly 11% of the entire mortgage application, according to the MBA. Compared to the beginning of the year, it rose almost three fold from 3%.
While interest in ARMs waned due to the role they played in the housing crash of 2008, borrowers’ demand for ARMs are back. Whether demand for ARMs will grow largely depends on mortgage rates and liquidity in the secondary market, mortgage executives and analysts said.
Stricter regulations, new guidelines
The share of mortgage applications for ARMs is still below the historical average between 1990 and 2022 of 12.49% and significantly lower than the peak of 36.6% in 2005, the MBA said. Even if more borrowers opted for ARMs in a rising rate environment, stricter underwriting policies for ARMs and laws that keep lenders in check will prevent borrowers from being trapped in loans they could not afford, as occurred in the mid 2000s, said Keith Gumbinger, vice president at HSH Associates.
Leading up to the housing crisis, many subprime lenders provided borrowers with interest-only ARMs, which initially offered low rates. Some buyers who couldn’t qualify for a conventional mortgage turned to an ARM to make lower monthly payments.
“Not only could you get a loan if you had terrible credit (in the mid-2000s), but you could get a loan if you had terrible credit and almost no down payment,” said Gumbinger. “You were able to get an ARM by not even providing any documentation for your income or assets.”
The mortgage industry is different from 14 years ago. New underwriting guidelines for ARMs make it harder for borrowers to find themselves in foreclosure and regulations cap rate adjustments, which limit percentage increases per period and over the life of the loan.
The 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, created in direct response to the financial crisis, requires lenders to check a buyer’s ability to repay (ATR), which protects them from predatory lending practices.
“Not a one-size fits all”
The surprising surge in rates – up from 3% in January to over 6% in June – breathed new life into ARMs on the demand side, especially for loans with large balances. But from the supply side, there’s not a lot of liquidity in the secondary market.
ARM loans are not yet showing up in significant volume in the mortgage-backed securities (MBS) private-label market “because most of the deals that we’ve seen so far this year are from 2021,” Maria Luisa De Gaetano Polverosi, associate managing director at ratings agency Moody’s Investor Services, said during a panel at the MBA’s Secondary and Capital Markets Conference & Expo in New York City in May.
The difference between a 30-year fixed-rate mortgage and an ARM loan, or the spread is not wide enough, meaning “there’s not enough benefit for the borrower to present it,” said Paul Blaylock, CEO of Tampa, Florida-based LoanFlight said.
In the most recent Freddie Mac PMMS Mortgage Survey, which tracks purchase mortgage rates, the 30-year fixed-rate mortgage last week averaged 5.23% while the 5-year ARM averaged 4.12%. (The survey was published June 9, a day before mortgage rates soared on news of worse-than-expected inflation numbers and fears of the Federal Reserve’s forthcoming rate hike response.)
“It’s not a one-size fits all thing,” said Paul Blaylock, CEO at LoanFlight. “But it should make sense to most people that if the difference between an ARM and a 30–year fixed-rate mortgage is very small, then it might not be worth the risk of having a rate that could adjust and go much higher in three or five or seven years.”
When ARMs do start showing up in securitization deals, Polverosi, said Moody’s is well-equipped to assess the risk of the offerings. “We have a lot of data on those (ARMs), and our models are built to assess that risk,” she added.
New ARM products
Lenders are taking notice of the rising mortgage rates and double-digit home price growth with lenders rolling out new ARM products.
Michigan-based wholesale lender Homepoint rolled out a jumbo ARM product in May offering a maximum loan amount as much as $2.5 million. Homepoint’s jumbo ARMs have a seven- or 10-year fixed-rate period and the loan adjusts every six months. Since the launch last month, Jumbo ARMs represented 28% of its jumbo business, the lender told HousingWire.
“Homebuyers today have a stronger interest in adjustable-rate mortgages because they provide a solution to affordability issues caused by the recent increase in interest rates,” Phil Shoemaker, president of originations at Homepoint, said in a statement.
Credit Union of Southern California started offering interest-only ARMs last month, in which the borrower delays paying down any principal for a period of time. Available as purchase or refinance loans, the rates are offered in five- and seven-year terms for primary residences $3 million and under, or for second homes for $2.5 million and under.
“As rates get higher it might make sense for certain borrowers who are in the right financial situation to get ARMs to be able to enter into homeownership and sort of utilize that home equity building,” said MBA’s Kan. Borrowers need to understand that they may need to refinance before the fixed-rate period expires, sell the home, or be prepared to make higher payments, said Kan.
It’s important for clients to see their options between ARMs and a fixed-rate mortgage and see what the differences are, Neat Home Loans’ Johnson said. The difference in cash required to close a loan, the difference in loan payment based on how long borrowers plan on living in the home, and the tax write-offs based on the borrower’s tax bracket are all things loan officers will need to inform borrowers.
“For the next six months, we expect ARMs to have some popularity,” said Johnson. “It’s not a bad thing for borrowers, lenders, and loan investors. For loan officers that didn’t grow up in the subprime crisis, they might need to dust up the ability to explain these (ARM) programs, do the calculations for clients to introduce the new programs.”
Could you comment on the lack of attractive ARM pricing from Fannie/Freddie due to the flat yield curve? It appears only institutions lending deposits (CU’s and Banks) are offering competitive ARMs in the conforming loan space.