[This article is the first in our three-part series on adjustable-rate mortgages (ARMs). We will dive into what ARMs are, how they work, and the situations in which a borrower might be interested in pursuing one. To access the rest of the series, click here.]
You’ve probably been hearing a lot of talk these days about adjustable-rate mortgages, otherwise known as ARMs. But unless you’ve been in the mortgage industry for quite some time, you may not have much experience with these loan products. That’s because interest rates have been so low for so long, ARMs didn’t make sense for most borrowers.
With rates rising, however, ARMs have quickly become a valuable tool for first-time homebuyers dealing with a tough housing market. And in order to sell ARMs, you must understand them well enough to advise your clients on whether they are the best choice for them.
Why ARMs Are Getting Hot
Within the first six months of 2022, mortgage interest rates had climbed to the highest level in more than a decade. Combine this fact with record home prices, and you have one of the most challenging markets for first-time homebuyers in a long, long time.
Fortunately, there are still ways to help your clients get into the home of their dreams. One of the best is an ARM, particularly since the introductory rate is usually lower than the typical 30-year fixed rate.
For this reason, ARMs are quickly gaining favor among today’s buyers. According to CoreLogic, ARM loans accounted for roughly 8.5% of all home mortgages originated in May 2022, up from 3.5% of all mortgages in May 2021. And here at Enact, the volume of ARMs we insure has doubled since last year as well.
A Few ARM Basics
An ARM is what it sounds like – a mortgage loan with a rate that adjusts over time. Typically, an ARM starts off with a low rate that is tied to a particular index. Lenders add a margin to the index that is fixed for the length of the loan term, which is usually 15 or 30 years. Over time, as the index rate changes, the ARM rate changes with it.
We’ll delve deeper into how ARMs work in our next post on this series. But for now, it’s useful to know the typical ARM has five components to it:
- The initial rate, which is the rate the mortgage starts off with. This also ties into the adjustment period, or the period until the rate and monthly payment changes. The initial rate is fixed for a certain amount of time, such as three, five, seven or ten years. For instance, an ARM with an initial adjustment period at three years, is referred to as a 3 year ARM.
- The change frequency, or how often the rate adjusts after the initial fixed rate. Usually, this is every six months or every year.
- The initial adjustment cap, which is the maximum amount the rate can change after the fixed rate period expires.
- The subsequent adjustment cap, which is how much the rate can change each time after the initial adjustment.
- The lifetime cap, or the maximum level the rate can increase over the life of the loan.
For example, a 5/1 ARM has a fixed rate for the first five years. After that five-year period, it adjusts once, and then once every year afterwards. Meanwhile, a 7/6 ARM has a fixed rate for seven years, and after the first adjustment, it adjusts every six months until the loan is paid off.
Pros and Cons
The most important thing to remember about ARMs is that they aren’t for everyone. Your customers should weigh the pros and cons of these products very carefully—and they will need your expert guidance as they do so.
The biggest benefit of an ARM is that the initial rate is typically lower than 30-year fixed-rate mortgages—often by 1% or more. This means that your buyers can get into a new home with a much lower payment—at least initially—than they would with a fixed rate loan.
The primary drawback is that loan interest rate could increase over time. Because there’s no crystal ball to tell us where rates are headed, some clients will be naturally nervous about ARMs and whether they can afford a higher payment in the future.
For reasons like this, ARMs usually work best for borrowers who are likely to sell their home before the initial fixed rate expires, or who have reason to believe their income will increase in the future, making a potentially higher payment more affordable.
Want to Learn More?
In our third post in this blog series, one of our loan experts will offer some tips on advising your clients on ARMs. In the meantime, feel free to reference our flier on ARMs basics and share it with your clients. And because going the extra mile for our customers comes naturally to us, we even offer a training course on ARMs, too.
We offer coverage for most ARM loans at very competitive rates. We’re also dedicated to seeing every one of your transactions to the finish line and beyond. For more information, simply contact your Enact Sales Rep.
You can also access our Enact’s Guide to ARM Loans: The Basics flier below. It’s a great resource to reference for you and your borrowers.
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