Homeowners opt for ARMs instead of fixed mortgages for a number of reasons, but it’s mostly to save money.
After all, adjustable-rate mortgages are offered at a discount compared to fixed mortgages, and the level of discount varies based on how long the ARM is fixed.
The shorter the fixed-rate period on an ARM, the lower the interest rate. So if you want the lowest rate, you need to go with a one-year ARM as opposed to a 7/1 ARM.
Back in the mid-2000s, it wasn’t uncommon to see 1-month and six-month ARMs, which adjusted after just a month and six months, respectively.
Clearly this made for a lot of uncertainty, especially for less sophisticated homeowners who were often aggressively pitched such mortgages.
To make matters worse, lenders offered better pricing, or rather commissions, on ARMs with prepayment penalties.
Long story short, a ton of naïve homeowners wound up with short-term ARMs and three-year prepayment penalties, meaning they couldn’t refinance (or even sell in some cases) once interest rates went up.
As home prices tanked and monthly mortgage payments went up, the housing market imploded. The irony is that many of those who took out ARMs before the most recent housing crisis (to save money) lost their homes because of them.
Could We Repeat History Again?
But times have changed, right? Perhaps. The prepayment penalty is largely a thing of the past, and ARMs are a lot less popular these days thanks to ultra-low fixed rates.
However, the ARM-share of mortgages has been inching up lately, mainly because home prices are on the rise and borrowers see value in getting a discount for the first several years of their loan.
There also seems to be this belief that rates aren’t going to rise anytime soon, so why not go with an ARM and save lots of money?
Unfortunately, it’s that line of thinking that could land a lot of these borrowers in a tough spot a few years down the road, even if they qualify at the fully indexed rate today.
First off, payments can become unmanageable after a reset, especially if the borrower’s financial situation changes for the worse. And let’s face it; nobody’s job/income is set in stone.
Secondly, if rates do rise and you seek a refinance, you need to qualify. It’s never a guarantee to qualify for a mortgage. It’s also not cheap to refinance.
To alleviate some of these concerns, two financial literacy advocates have come up with a few ways to make ARMs safer.
Introducing the Safer ARM
John Bryant, the founder of Operation HOPE, and Robert Gnaizda, a founder of Greenlining Institute, have proposed a few ways we could make mortgages safer without impeding access to credit.
Their first suggestion is to require non-profit financial education before a low- or moderate-income family can take out any type of ARM, or interest-only mortgage for that matter.
Secondly, they believe no ARM should have a term that is less than the median time Americans own their primary residences, which is roughly seven to nine years.
In other words, you would only be allowed to take out a 7/1 or 10/1 ARM, and if you were considered a low- or moderate-income borrower, you’d have to complete a homeowner education class as well.
The pair also believes no institution should be able to offer interest-only mortgages to borrowers with less than a $5 million net worth. Don’ worry Mark Zuckerberg, you’re okay.
They argue that had these measures been in place a decade ago, the crisis would have never happened.
Reforming the QM Loan
Aside from taking issue with ARMs and IO options, Bryant and Gnaizda think the Qualified Mortgage rule could benefit from some tweaks as well.
They believe Fannie Mae and Freddie Mac should consider any 30-year fixed mortgage with a minimum seven percent down payment as a QM loan.
But only if the borrower’s income doesn’t exceed the median and the home is valued at no more than 90% of the region’s median price.
These loans wouldn’t require mortgage insurance either, though lenders would be able to charge a premium of 50 basis points for the first five years of the loan to compensate for risk (and even longer if the borrower fell delinquent).
Again, these borrowers would have to complete both pre- and post-financing education, though they could also receive a temporary waiver for up to six months of housing payments if unemployed or sick after five years or more of homeownership.
They plan to discuss these ideas with financial institutions, though similar warnings/suggestions thrown around a decade ago seemed to fall on deaf ears.