Freddie Mac has conducted its 30th annual adjustable rate mortgage (ARM) survey and the hybrids have it!
Intro period interest rates have increased year-over-year. However, ARMs use, in general is still at historic lows. At the time of the survey, the 30-year fixed rate mortgage (FRM) interest rate registered at 4.51%. The intro rate for a 5/1 hybrid ARM (the most popular ARM, according to Freddie Mac) was a scant 3.15%, reminiscent of the FRM rates of yesteryear.
Check out the following chart, which shows the historic development of ARMs use. Note that their use overall trends downward in a falling interest rate environment. But hybrid ARMs have continuously increased in popularity.
Chart courtesy of Freddie Mac
Frank Nothaft, Vice President and chief economist at Freddie Mac, was quoted as saying borrowers have preferred FRMs for the past several years since rates have been historically low. But he went on to say,
“As longer-term rates rise, ARMs with their lower initial interest rates will become more appealing to loan applicants. Hybrid ARMs are particularly attractive because they have an initial extended fixed-rate period of 3 to 10 years.”
What Mr. Nothaft has to say is absolutely right, and it’s terrifying.
We follow the ARM-to-loan ratio in the state of California very closely as it is an indicator of the housing market’s stability. ARMs use typically rises when the cost of homeownership rises out of reach of average end-users, either through an increase in interest rates, prices or both.
The ARMs ratio has remained under control in California despite the unusual dual increase of prices and interest rates and dismally low buyer purchasing power (BPP). But it won’t stay that way for long. If prices and/or interest rates do not decline quickly enough to make for reasonable BPP, ARMs are going to step in to fill demand.
The terrifying thing about all this is that the “popular” hybrid ARM is an insidious little beast capable of doing real damage to the real estate market. “Hybrid” is really a euphemism. It is more appropriate to call them “imposter loans.” That’s because they look like FRMs, for quite some time. But after five years, the loan resets to current market rates. Rest assured, interest rates are going to be much higher five years from now and borrowers who overreach today with a 5/1 hybrid ARM are going to be sorry.
A better solution is low-rate loan assumptions. But that’s a whole other story.
The article is a very one-sided analysis. Hybrid ARMs have a lot of advantages besides the lower initial rate. Many borrowers with hybrids have been pleasantly surprised to have rates that fell into the 3’s or 2’s, where they will likely remain for another 1-2 years. Hybrids also allow borrowers to match their expected occupancy with the fixed term. Why pay for 30-year fixed, if you expect to move in 5-7 years? Hybrids can also be a good solution for borrowers who expect to stay in the home but will be making a large principal payment prior to the end of the fixed term; the ARMs will automatically re-amortize to a lower payment based on the reduced principal and remaining term. Yet another good place for the hybrids is for borrowers who are nearing retirement and want to pay off principal as fast as possible before switching to a reverse mortgage; the hybrids will leave them in better shape upon retirement. So while the hybrids are definitely not for all borrowers, the article’s blanket condemnation is seriously misleading.
Finally, the article’s suggestion to seek assumables is mostly a pipedream. The only remaining fixed rate assumable is VA, whose borrowers may not want to tie up future eligibility by allowing an assumption. [FHA remains assumable, but the new, higher m.i. kills most of the advantage unless rates jump dramatically.]