More Borrowers Are Using Adjustable-Rate Mortgages. Are They in Trouble?

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  • With mortgage rates rising, more borrowers are turning to adjustable-rate mortgages.
  • Adjustable-rate mortgages were a primary contributor to the 2008-2009 mortgage crisis, but they are different this time around.
  • While ARMs aren't for everyone, they could be a great fit for certain borrowers.

ARMs are making a big comeback, but are these loans a good idea?

Adjustable-rate mortgages, or ARMs, were a popular way to finance homes in the 1990s and 2000s, but declined in popularity 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 for much of the time since then, they weren't as necessary for keeping mortgage payments affordable.

Now, with mortgage rates on the rise and home prices spiking higher, ARMs are starting to make a comeback. During the first half of 2022, ARMs rose from 3% of all mortgage loans to 10% -- more than tripling in popularity.

The exact numbers vary constantly, and will depend on the mortgage lender you consider, but as I write this, one popular lender is offering 30-year fixed-rate mortgage loans with a 5.75% interest rate for well-qualified borrowers, and has a 4.5% rate listed for a 5/1 ARM. On a $400,000 loan, this is the difference between a $2,334 monthly principal and interest payment and a payment of $2,027. With numbers like this, it's not surprising 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 late-2000s mortgage meltdown that led to the Great Recession. But it's important to realize that these aren't the same loans that were widely used back then. There are a few differences:

  • The ARMs being used in the 2000s were often given with no money down. In fact, some lenders even made loans for more than the home's purchase price and let the borrower start the loan term underwater.
  • Borrowers could get an ARM with little or no credit, income, or assets. These were infamously referred to as NINJA loans (no income, no job or assets).
  • Many ARMs were given with exotic loan terms, such as interest-only repayment.
  • There was often no cap on how quickly the mortgage rate could adjust. It wasn't uncommon for borrowers' payments to double or more overnight.

Today, ARMs are much safer. They have the same (or tighter) credit standards than their fixed-rate counterparts, and to prevent borrowers from being blindsided with massive monthly payment increases, they generally have a cap that governs how quickly their rates can rise at once. In short, while ARMs aren't a good fit for every borrower, they don't pose anywhere near the systemic risk they did prior to the financial crisis.

Is an adjustable-rate mortgage right for you?

While this generation of adjustable-rate mortgages are far from the predatory lending practices of a couple decades ago, that doesn't mean they're right for everyone.

ARMs are most appropriate for home buyers who:

  • Aren't expecting to be in their home for more than a few years. In other words, if you anticipate selling the home before the initial rate period expires, you don't need to worry about your monthly payment increasing.
  • Are expecting to be able to refinance in a beneficial way prior to the initial rate period expiring. Nobody can predict where interest rates will be in five or seven years, but as an example, maybe you're just now establishing credit and have only a so-so FICO Score. If you can refinance in five years with top-tier credit, using an ARM now could be a good move.

If you do use an ARM to buy a home, it's important to be fully aware of the drawbacks -- particularly how often your rate can be adjusted, how the new rate will be calculated, and how much your rate (and monthly payment) could increase at any one time.

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