Mortgage rates jump above 4% — prompting borrowers to return to a staple of the housing bubble

It's increasingly expensive to buy a home: Not only are housing prices increasing by double-digits annually, but mortgage rates have been on the rise and recently reached 4.4% for the first time since March 2019. That's pushing more buyers to take out adjustable-rate mortgages — one of the financial products blamed for the 2006 housing crisis. 

The share of mortgages that are adjustable-rate mortgages (ARMs) doubled to 10% in January, up from a 10-year low of 4% in January 2021, according to data from CoreLogic. ARMs offer an initial low rate for a period of years — typically anywhere from three to 10 years — and then the rate adjusts after that, usually annually, based on a fluctuating benchmark rate plus an additional margin, such as 2%. 

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The reason for the resurgence in interest in ARMs is clear: These loans offer an initial rate that's far lower than a conventional 30-year mortgage. For instance, the average initial rate for a 5/1-year ARM (an ARM that is fixed for five years, and then resets every year after that) stands at 3.36% — more than one full percentage point lower than the 4.42% current rate for 30-year mortgage, according to Freddie Mac. But of course, once that five-year initial rate expires, buyers can get hit with a higher rate — such as 5.36% instead of 3.36%. 

That initial rate can represent significant savings for homebuyers who are coping with record-high home prices. Median listing prices for properties have surged almost 27% since the start of the pandemic through February, reaching a high of almost $400,000, according to data from Realtor.com.

Looking at the math, that means a buyer who puts 10% down on a $400,000 home and finances the remainder with a 30-year loan at today's rates will have a monthly payment of $1,806. But the initial rate on a 5/1-year ARM would be $1,636 — a savings of about $2,000 annually. 

"When you see that prices are increasingly rising, having that purchasing power gives buyers more options for looking at a home," noted Brian Rugg, chief credit officer for loanDepot, a company that provides loans to consumers — including mortgages. "When you consider ARMs versus fixed rates, it gives you more flexibility."

The resurgence in interest in ARMs may raise questions about whether the housing market is echoing some of the trends of 2006, when home prices surged as buyers snapped up properties and lenders opened their wallets to provide loans. But financial experts say there are some differences between today's pandemic housing boom and 2006, such as banks' stricter lending standards. 

The jump in mortgage rates is pricing many buyers out of the market, the National Association of Realtors (NAR) said on Thursday. Since year-start, about 6.3 million households have been pushed out of the home-buying market, including 2 million millennial buyers, NAR said. NAR said it expects rates will climb even higher. 

"With long-term Treasury yields set to head higher, mortgage rates will go higher still in the near term," Tan Kai Xian, U.S. analyst with Gavekal Research, said in a report, adding that this will increase monthly housing costs and boost inflation. 

Bad reputation

Lending standards are stricter today than during the 2006 housing bubble, Rugg noted. In the housing run-up more than a decade ago, some lenders handed out so-called "liar's loans," or mortgages that required little or no documentation of income. Today, banks require buyers to verify their income to qualify for a loan.

Adjustable-rate mortgages got a bad name in the housing bubble because they were dangled at some buyers who couldn't qualify for a conventional mortgage. Since the initial "teaser" rate meant that those buyers' monthly payments were lower, lenders were more willing to push through the loans, according to research from Brookings Institution. 

That became problematic, however, when the housing market crashed and the ARMs reset to higher rates that those buyers couldn't handle.

But today, banks check to make sure that borrowers can handle adjustable-rate mortgages — including whether their income can absorb a higher rate once the initial period expires, experts say. Even though the share of ARMs is increasing, it's still far below where it stood in the mid-2000s housing boom, when more than half of new mortgages were adjustable-rate loans.

And there are also limits on how much an ARM can shift higher, minimizing the impact on borrowers. 

"Banks will make sure you qualify for that, and there are caps on rate changes," noted Melissa Cohn, the regional vice president of William Raveis Mortgage. "It's a whole different marketplace."

ARMs can be helpful for homebuyers who don't plan on staying in their home for more than a handful of years, noted Rugg of loanDepot. 

"It's ideal for people for whom it's not their forever home," Rugg said. "As a starter home, get a lower rate to build up income — and they can ultimately trade up and move into a larger home. That, for me, is how it's ideal."

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