Is the return of adjustable-rate mortgages a red flag?
Adjustable-rate mortgages, discredited until recently as one of the triggers of the housing crash, are making a comeback.
ARMs represented one-third of all home loans of $417,001 to $1 million originated in the last quarter of 2013, according to The Wall Street Journal. By comparison, the percentage of ARMs stood at just 22 percent a year earlier.
The return of the controversial product is largely due to its increasing popularity with wealthy homebuyers, who look to jumbo mortgages (those above $417,000) to finance their homes. The trend is also likely being driven by the rising housing prices in high-cost locations such as New York and San Francisco, where middle-class homeowners need jumbo loans to buy even modest two- or three-bedroom homes. In that case, turning to an ARM might raise red flags.
"When you talk about another middle-class buyer getting an ARM, that's when you have to ask a lot of questions," notes Polyana da Costa, senior mortgage analyst at Bankrate. "I would only recommend an ARM if they know for sure they won't keep a house for more than five or seven years. Otherwise, the risk is just too big."
ARMS work by offering a lower initial rate -- for five years, for example -- which then resets after that period ends. The danger is that the rate reset can jump significantly. When housing prices fell during the financial crisis, some homeowners found themselves unable to sell their homes or refinance into lower-rate loans.
The renewed popularity of ARMs is now due to demand from high-net-worth buyers, who are taking out the loans as a way to keep their cash free to invest elsewhere, da Costa notes. For the rich who turn to ARMs as an investment strategy, the mortgages may pose little risk, given they may be able to refinance, turn to cash or pull funds from another investment when the loan resets.
Still, adjustable-rate loans are gaining traction, albeit at a slower rate, among all homebuyers, according to mortgage giant Freddie Mac. One in 10 new home loans were ARMs in 2013, and that figure is likely to rise to 12 percent this year, Freddie Mac chief economist Frank Nothaft said in January.
If ARMs can be risky, the borrowers who are turning to such mortgages tend to be in better financial shape than the millions of people who used "balloon," negative-amortization and other questionable products in the run-up to the housing bust. The average credit score for ARM borrowers as of the fourth quarter was 762, compared with 693 in 2006, The Journal notes.
Taking on the risk of an ARM also carries some reward: a 5/1 ARM now offers an initial rate of 3.3 percent, while a 30-year fixed loan is currently at 4.5 percent, according to figures from Bankrate.
While the adjustable rate might be tempting, homebuyers should ask themselves some hard questions before signing onto an ARM, da Costa said.
"Who knows what rates will be in five to seven years? What if you can't sell the house? These are questions homeowners didn't ask during the last housing boom," she said. "I would recommend anyone considering an ARM to do a lot of research about it and look into what happened during the last crisis."