ARMs race builds amidst rising mortgage rates

An adjustable-rate mortgage grows house-buying power by $44,000, analyst says

ARMs race builds amidst rising mortgage rates

In a lending environment marked by rising mortgage rates, adjustable-rate mortgages can help prospective home buyers recapture of their house-buying power.

That’s the premise of First American Financial Corp. analysis via its Real House Price Index, which jumped by 50.8% year over year – the fastest growth in the more than 30-year history of the series. According to analysts, the annual decline in affordability was driven by a 20.1% annual increase in nominal house prices and a 2.3-percentage-point increase in the 30-year fixed mortgage rate compared with one year ago.

The financial climate has led to nothing short of an ARMs race among consumers, suggested American Financial’s chief economist, Mark Fleming. “Consumer house-buying power, how much one can buy based on average household income and a given mortgage rate, increases when the mortgage rate drops,” he said. “In fact, at those rates, an ARM increases consumer house-buying power by nearly $44,000 when compared with a traditional 30-year, fixed-rate mortgage.”

That difference is nothing short of a game changer – particularly for first-time homebuyers, he suggested. “Because ARMs offer a lower mortgage rate, there has been a steady increase in the share of ARM loans as mortgage rates have increased,” Fleming said. “For the month of May, the average share of ARM loans was up to 9.8 percent, compared with 3.9 percent one year ago. As all mortgage rates continue to increase, the share of ARM financing will likely increase.”

Read more: What’s the verdict on adjustable-rate mortgages?

The findings were revealed in the May 20222 First American Real House Price Index, which measures the price changes of single-family properties throughout the US adjusted for the impact of income and interest rate changes on consumer house-buying power over time at national-, state- and metropolitan-area levels.

First American is a premier provider of title, settlement and risk solutions for real estate transactions and a leader in the digital transformation of the mortgage industry.

Given that the RHPI adjusts for house-buying power, the index yields a measure of housing affordability.

“For home buyers, one way to mitigate the loss of affordability caused by a higher mortgage rate is with an equivalent, if not greater, increase in household income,” Fleming added. “Even though household income increased 4.6% since May 2021 and boosted consumer house-buying power, it was not enough to offset the affordability loss from higher mortgage rates and fast-rising nominal prices.”

Read next: Adjustable-rate mortgages – the answer to housing market volatility?

The findings come as affordability wanes, prompting homebuyers to explore ARMs for the lower rate benefit, Fleming explained. “Given the lower mortgage rate that is typically offered on an ARM today, compared with the 30-year, fixed-rate mortgage, ARMs offer prospective first-time home buyers an option to recapture some house-buying power in a rising rate environment.” 

Such economic changes have given rise to ARMs to mitigate the mercurial market. “While the rates on ARMs have increased too, ARMs have lower rates than 30-year, fixed-rate mortgages,” Fleming noted.

“According to the Mortgage Bankers Association’s weekly survey, the 30-year, fixed-rate mortgage was 5.45% in May, while the average rate on a five-year ARM was 4.46%.”

Today’s ARMs are markedly different from those of yore – namely during the Great Recession of 2008, Fleming stressed. “While ARMs were a symbol of the housing market crash, today’s ARMs are very different,” he said.

“They offer reduced risk of significant payment shock when the fixed-rate period ends and rates become adjustable. As long as the ‘spread’ between ARMs and fixed-rate mortgages continues, more first-time home buyers may choose ARMs because the lower mortgage rate gives them a purchasing power ‘boost’ over the 30-year, fixed-mortgage rate.” 

Considering current market conditions, Fleming joins a growing chorus of experts espousing ARMs as an alternative to inflation’s corrosive economic effects. In an interview with Mortgage Professional America last month, 40-year industry veteran Melissa Cohn, regional vice president of William Raveis Mortgage, also talked up ARMs as a mitigating alternative. Like Fleming, she contrasted ARMs of today with those 15 years ago.

“That’s like talking about the Old World,” she said at the time. “Adjustable rates are a very different animal today. The adjustable-rate mortgages that gave ARMs a bad name and reputation were loans with which monthly payments were not sufficient even to cover the interest that was due on the mortgage and the loan negatively amortized, meaning that each payment you made was only a partial payment of the interest due. Instead of paying down your mortgage, the principal balance grew each month. Those mortgages don’t exist today, except in very rare exceptions.”

Today’s version is decidedly different, she added. “Adjustable-rate mortgages today are loans that amortize,” she said. “They walk, talk and act like a fixed rate for the initial rate period.”

Today’s ARMs offer flexibility too, she noted: “You can get an adjustable rate for three years, five years, seven, up to 15 years. Let’s say there’s a seven-year adjustable: During the first seven years, it’s a fixed rate as far as you know. The monthly payment is interest and principle; you’re paying down your loan the same way; you’re amortizing it the same way you would with a 30-year fixed.

“At the end of the initial rate period, there are adjustments,” Cohn added. “You’re never negatively amortizing the loan. There are caps, formulas that determine what the rate will be using well known, easily found indices such as the 10-year Treasury or the new SOFR Index. They act as a great bridge.”