Americans Gambling on Rates with Most ARMs Since 2008
Jung Lim plans to offset the cost of rising mortgage rates by using an adjustable-rate loan to buy a home for his expanding family. For the California endodontist, the money he'll save makes up for the ARM's risky reputation.
Lim, 38, whose wife is expecting a second child in December, is leaving a two-bedroom condo in Los Angeles's Hancock Park to buy a four-bedroom house in the city's Sherman Oaks neighborhood for $1.12 million. His lender offered him a rate for an adjustable-rate mortgage that is about a percentage point cheaper than a fixed loan.
"If I could have gotten a 30-year fixed at the interest rate I'm getting the ARM for, I would have felt a lot more comfortable," said Lim, who's also a professor of endodontics at the University of California, Los Angeles. "But I'm hoping to refinance in five years or less. And we'll be in the house for about 10 years so we could also sell. Hopefully prices have bottomed so we won't be underwater then."
In the second year of the U.S. housing recovery, the loans that helped trigger the housing bust are making a comeback. Applications in late June rose to the highest level since 2008 after the Federal Reserve sent fixed rates surging by signaling it may curtail bond buying credited with pushing borrowing costs to the cheapest on record. The average 30-year fixed-rate mortgage jumped 1.2 percentage points in mid-July from May to the highest level in two years, adding about $200 a month to payments on a $300,000 mortgage.
"We've seen a shift in the way people look at adjustable-rate mortgages," said Cameron Findlay, chief economist of Discover Financial Service's home-loan unit. "They're still skeptical about using ARMs, given the role they played in the financial crisis, but the sticker shock of what fixed rates have done is making them look for alternatives."
ARMs, loans with interest rates that adjust after initial fixed periods, usually of five, seven or 10 years, helped fuel the housing bubble and contributed to soaring defaults in 2008 that sent the economy into a tailspin.
In addition to loose underwriting standards that extended mortgages to people who couldn't pay, variations included loans that had interest-only periods or initial teaser rates that became known as exploding ARMs when the rate spiked. Lending was based on the presumption that house prices would keep rising and the debt could be refinanced before onerous terms kicked in.
"When you give unqualified buyers a rate they won't be able to afford based solely on the presumption that home prices will always go up, it's not going to end well," said Keith Gumbinger, vice president of HSH.com, a Riverdale, N.J.-based mortgage website.
Home prices peaked in mid-2006 before starting a plunge that stripped a third off the value of properties in the biggest real estate bust since the Great Depression.
Home prices also are gaining at the fastest pace since the boom, with values up 2.4% in the second quarter from the previous three months, according to Zillow Inc., the biggest second-quarter gain since 2004. Sales of new properties rose more than forecast in June to the highest level in five years, the Commerce Department said Wednesday.
New lending regulations stemming from 2010's Dodd-Frank Act effective in January include an "ability to repay" measure that requires lender to make sure fixed-rate and ARM borrowers have the ability to make good on their payments.
Since the rules for ARMs usually allow borrowers to qualify on the loan's initial rate, some may not be able to afford their mortgages after the fixed period ends.
For now, ARMs are helping borrowers lower interest payments and reach for more expensive homes after financing costs rose.
In the last week of June, the dollar value represented by ARM applications accounted for 16% of mortgage requests, the highest share since July 2008, two months before Lehman Brothers Holdings Inc. collapsed, according to Mortgage Bankers Association in Washington.
Mark Baudler, a San Francisco attorney, last month traded a 30-year mortgage with a 4.5% fixed rate for an adjustable loan at 2.5%, cutting his $5,500 monthly mortgage bill almost in half.
"I'm going to take the money I save and plow it right back into the mortgage," said the partner at Wilson Sonsini Goodrich & Rosati, a law firm that specializes in securities and intellectual property law. "If the rates go nutty when the loan adjusts, I'll be able to handle it."
Others, like Los Angeles buyer Lim, are basing their decision to get an ARM on their plans to move from a property in a set number of years. Vivian Cohn in Hollister, Calif., lowered her monthly mortgage payments to about $940 from $1,400 in May when she took out a 5-1 ARM, meaning the rate is fixed for the first five years. After that, her 2.2% initial rate could adjust as much as 5 percentage points higher.
Cohn doesn't see the threat of a rate change as a problem. When she retires in two years, she and her husband are moving to Panama, Cohn said. If they can't sell the house at that point, they'll rent it for the following three years and sell then, before the loan adjusts, said the 60-year-old human resources manager at a Silicon Valley company.
"A fixed rate isn't for everybody," Cohn said. "We know we're moving so there's no point in paying for a guaranteed rate if we won't use it."
Regardless of how confident borrowers are of their plans to stay in a home for a limited time, there are no guarantees home prices will provide them the opportunity to refinance or sell, said Erin Lantz, director of Zillow's Mortgage Marketplace, an aggregator of loan rates.
"On a national basis, home prices probably will continue to rise, but it's more difficult to predict by region," Lantz said. "If you go underwater, you're going to have to bring money to the table to get out of that mortgage."