As mortgage interest rates rise, adjustable-rate mortgages (ARMs) become more popular, and they now make up 12.0 percent of total production, up from 3.3 percent in November 2021.
This development has alarmed many housing market observers who, informed by their experiences with subprime mortgages from 2005 to 2008, worry ARMs are risky and that future mortgage payments could become unsustainable for borrowers as rates rise.
Are they right to be concerned? Not according to the research, which shows today’s ARMs are no riskier than other mortgage products and that their lower monthly payments could increase access to homeownership for more potential buyers.
What a borrower should know about ARMs
ARMs predate the last housing bubble. Among mortgages originated from 1995 to 2004, the average ARM share was 18.3 percent. What is atypical is the very low ARM share, by historical standards, from 2010 to 2021, driven in part by ultra-low interest rates during this period.
Before 2005, lenders held ARM borrowers to higher lending standards than borrowers who took out fixed-rate mortgages, requiring higher credit scores, higher incomes, and larger down payments to compensate for the higher risk. Borrowers understood how their mortgages worked, and there were no market hiccups.
Compared with homeownership rates in other developed countries, the US rate is slightly below average. And for most developed countries, ARMs are the go-to mortgage product; only the US and Denmark offer 30-year fixed-rate mortgages.
ARMs generally have interest rates lower than the 30-year fixed-rate product. Mortgage rate attractiveness is measured by the difference between the current mortgage rate and the average 30-year mortgage rate over the preceding three years. When rates are attractive, this difference trends negative; when rates are less attractive, the difference trends positive.
When mortgage rates are attractive, the ARM share is low, because borrowers want to lock in their rates for 30 years. When rates are less attractive, ARMs allow borrowers to save money given the lower rates, and the borrower can refinance if rates drop. Of course, if rates keep rising, ARM monthly payments will rise over time.
Today’s ARMs are not crisis-era ARMs
The risks of ARMs were substantially mitigated by the regulatory reforms put in place after the 2008 bust. Today’s ARMs are not the risky products of 2008 or even the prebubble version. Instead, they are fully amortizing mortgages with initial fixed terms of 5, 7, or 10 years and are subject to an interest rate reset each year thereafter. (ARMs are usually referred to as 5/1, 7/1, and 10/1, depending on the length of the initial reset period.)
Our calculations of Fannie Mae and Freddie Mac data from 2020 to 2022 indicate 19.5 percent of ARM originations have an initial fixed term of 5 years, 47.8 percent have a fixed term of 7 years, and 32.7 percent have a fixed term of 10 years. These mortgages reset annually after the fixed period ends.
This contrasts sharply with the 2005 to 2007 subprime ARMs, which generally had fixed terms of two or three years, and the rate for that initial period was often “teased” down; it also contrasts with the so-called negative amortization product, where the initial payments did not cover the full principal and interest payments on the loan and the loan balance was permitted to grow. It was this layering of risk— where risky products are provided to less-creditworthy borrowers, often without income verification—that set borrowers up for failure.
In comparison, the risk profile of today’s ARMs, like that of prebubble ARMs, is stronger than that of fixed-rate mortgages. The most recent data show ARM borrowers have higher FICO scores and lower loan-to-value ratios and are more affluent, as measured by their higher home values and larger loan balances. And borrowers taking out ARMs during this period received mortgage rates 0.58 percent lower, on average, than the fixed 30-year rate.
Credit Characteristics of New Government-Sponsored Enterprise Borrowers
ARMs versus Fixed-Rate Mortgages
FICO | LTV ratio | Loan amount | Home value | Rate | ||
June–August 2022 | ARM | 762 | 75 | $354,500 | $498,641 | 4.92 |
Fixed | 753 | 80 | $283,333 | $383,199 | 5.50 |
Source:Urban Institute calculations of eMBS data.
Notes: ARM = adjustable-rate mortgage. LTV = loan-to-value.
Today’s ARMs also contrast with the so-called 1/1 and 3/1 ARMs of the late 1990s and early 2000s, for which payments were fixed for an initial period of just one or three years. After the financial crisis, the Consumer Financial Protection Bureau implemented an ability-to-repay rule, essentially requiring that mortgages be fully amortizing and that the lender qualify the borrower at the highest rate they could experience in the first five years. The result: very few ARMs have a reset period shorter than five years.
Finally, ARMs tend to have caps at the reset. For example, today’s government-sponsored enterprise (GSE) ARMs, 5/1s have a maximum increase at the first reset of 2 percent, and 7/1s and 10/1s have a maximum increase at the first reset of 5 percent. For subsequent resets, the usual adjustment is a maximum of 1 percent. And most ARMs have a 5 percent lifetime cap—the rate cannot increase by more than 5 percent over the life of the loan. The reset caps are more meaningful the longer the initial period.
Should more borrowers take advantage of ARMs?
ARMs offer considerable interest rate savings, even with today’s inverted yield curve, in which shorter-term rates are higher than longer-term rates. On November 3, the rate on a 30-year fixed-rate mortgage was 6.95 percent and the rate on a 5/1 ARM was 5.95 percent, a 100 basis-point differential. And this is typical: in 2022, the differential has averaged 109 basis points.
Consider the savings on a $375,000 loan (close to the 2022 GSE average): For a 30-year fixed-rate mortgage at 6.95 percent, the monthly payment is $1,820. For a 5/1 ARM at 5.95 percent, the monthly payment is $1,640—nearly 10 percent less.
The ARM saves the borrower $2,160 per year—almost $11,000 over the five-year initial reset period. Even if the borrower doesn’t have an opportunity to refinance and the rate resets up, the borrower’s income would likely be higher after five years, which could help keep payments manageable.
Many borrowers buy a home anticipating to keep it for fewer than 10 years. For these borrowers, ARMs are highly economical when rates are higher. Even for those planning a longer holding period, an ARM allows for lower payments during the fixed period and preserves the option to refinance. This could help more renters transition to homeownership and access all the financial security and wealth-building benefits it provides.
ARMs are no longer something to fear—in fact, they could help borrowers save money and reduce barriers to homeownership.
