What is the biggest challenge in today’s housing market?

  • interest rates (71%, 48 Votes)
  • the economy (16%, 11 Votes)
  • low inventory (9%, 6 Votes)
  • politics (4%, 3 Votes)
  • declining home prices (0%, 0 Votes)

Total Voters: 68

Instability in the housing market

Here’s a riddle: What allows homebuyers to pay more money, but has the potential to blow up their finances in five short years?

… Need a hint?

The share of mortgage applicants seeking to take out an adjustable rate mortgage (ARM) has jumped from 3.1% a year earlier to 12.7% at the end of October 2022, according to the Mortgage Bankers Association (MBA).

2022’s rapid pace of interest rate increase has left mortgage-reliant homebuyers floundering to keep up. As evidence, due to interest rate hikes alone, a typical California homebuyer today is able to borrow 31.3% less purchase-assist mortgage money than a year ago when mortgage interest rates were still near historic lows.

Related article:

Press Release: Buyer Purchasing Power Index plummets in Q3 2022

To make up the difference and regain lost purchasing power, desperate homebuyers have increasingly been turning to ARMs.

The average interest rate at the end of October 2022 is:

  • 7.16% for 30-year fixed rate mortgages (FRMs);
  • 6.39% for 15-year FRMs; and
  • 5.86% for 5/1 ARMs, according to the MBA.

As ARM rates have consistently hovered below FRM rates, ARM use has received a boost in 2022 — and with it, instability in the housing market.

ARMs are dangerous

ARMs provide a quick fix to homebuyers in search of more money. But the risks are clear.

The ARM rate homebuyers use to compare against FRM rates are just where the rate starts, called the introductory or teaser rate. During this introductory period — which is typically five years but can be anywhere from ten months to ten years — the homebuyer pays the low teaser rate.

Thus, while the lower rate saves homebuyers money during the short term, once the teaser rate resets and adjusts, their payment will also shift. How much it will shift is unpredictable — hence, the danger.

When rates reset, the result looking forward will be substantially higher payments — payment shock.

This was experienced on a large scale following the Millennium Boom when a whopping three-out-of-four homebuyers used ARMs to keep up with the rapidly rising price environment of the mid-2000s. Counseled to consider ARMs by lenders and agents alike, their motto was: “You can always refinance before the rate adjusts!”

But when their ARMs reset and payments rose beyond homebuyers’ ability to pay, homebuyers who had lost jobs during the Great Recession were unable to refinance and unable to sell due to their negative equity status. Their only option was foreclosure.

Much like during the post-Millennium Boom years, refinancing will be a less likely solution in the years ahead. This time around, interest rates are on the upward incline of the long-term rate cycle. Thus, ARM buyers today will only face higher and higher rates in the next decade.

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Investors eye future interest rates

The future of ARM rates

While ARM rates remain attractively low for now, they won’t remain below FRMs indefinitely.

The reason? ARM rates are directly tied to the Federal Reserve’s (the Fed’s) benchmark rate, which the Fed has signaled it will continue to increase in 2022. Thus, when the Fed raises rates, ARM rates rise an equal amount.

In contrast, FRM rates are heavily influenced by the bond market, which tends to accept lower long-term yields during times of economic uncertainty.

As the 2023 recession intensifies in the months ahead, expect the bond market to keep FRM rates from rising faster than ARM rates. Thus, an inversion in rates is likely in the months ahead, which will slash homebuyer appeal of ARMs instantly.

But for today’s ARM users, it will be too late.

Expect many of today’s homebuyers to regret their recent purchase. Home prices have already begun to dive here in California, plunging recent homebuyers underwater. Without significant down payments of 35% or more, recent homebuyers of all types will find themselves in a negative equity position within the next one-to-two years.

Then, it’s only a matter of time until the rate resets for today’s ARM buyers.

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Related article:

Homebuyers turn to ARMs in 2022 as FRM rates jump