Housing Affordability – Call to ARMs
September 6, 2022
Housing Affordability is negatively affected by both rising home prices and mortgage rates. A 20% increase in nominal home prices and a 2% increase in the 30-year fixed rate mortgage since January have contributed to a 46 point drop in the NAR Housing Affordability Index.
The Index was 143 in June 2021 and is 98.5 in June of 2022. The Housing Affordability Index indicates whether a median income family can qualify for a mortgage loan with a 20% down payment and 25% qualifying ratio for monthly housing expenses to gross monthly income.
100 points is considered the tipping point. As the Index rises above that point, housing is considered more affordable and as it declines, it is considered less affordable.
With affordability threatening to limit buyer’s ability to purchase, more borrowers are considering an adjustable-rate mortgage. For the last ten years, fixed-rate mortgages have been so low, only about 3% of borrowers used adjustable-rate mortgages.
There is a lot of misinformation about ARMs that keeps some would-be buyers from even considering them. Even before the housing crisis of 2007, many safeguards were put into place to protect borrowers.
“As long as the ‘spread’ between ARMs and fixed-rate mortgages continues, more first-time home buyers may choose ARMs because the lower mortgage rate gives them a purchasing power ‘boost’ over the 30-year fixed mortgage rate.” Mark Fleming, First American Chief Economist
The potential ARM candidate is probably not a first-time homebuyer. They should be tolerant to risk and more financially savvy with predictably increasing income. These buyers may recognize that they do not intend to stay in the home for a long time.
Adjustable-rate mortgages, generally start out at a lower-rate than a fixed-rate but can adjust, up or down, based on an independent index plus a specified margin and anniversary date that are referenced in the note. Most ARMs have stated interest rate caps that limit the amount of adjustment of the rate both on a periodic basis and a lifetime. FHA ARMs have a limit of 1% per adjustment period and a 5% lifetime cap over the original note rate. Conventional loans, more commonly, have a 2% per adjustment period and a 6% lifetime cap.
A particularly popular type of adjustable-rate mortgage is referred to as a 5/1 which means the rate for the first period lasts five years and then, each adjustment period after that is for one year. This allows a buyer to have stability in the rate during the first five years. If they plan to sell in less time than that, they will not have to deal with the adjustment.
A 5/1 ARM will have a lower payment for five years because of the lower initial rate and assuming a worst case scenario, a conventional ARM could increase a maximum of 2% at the end of the first period which would put the rate at higher than the fixed rate at the time they started. However, that is not where the breakeven point occurs. It is not until all the savings from the initial period have been exhausted, that the ARM will become more expensive than the fixed-rate alternative.
An ARM Comparison can help buyers to determine breakeven point. Let’s compare a 5.66% FRM with a 4.51% 5/1 ARM with 2 and 6 caps. A $450,000 30-year term loan amount will have a P&I payment of $2,600.41 for the fixed compared to $2,286.76 for the ARM. The $317.65 monthly savings will accumulate for 60 months plus a $6,673 lower unpaid balance on the ARM due to a lower interest rate.
The total savings in the first period would be $25,732. If you assume that the payment would increase to the maximum at each adjustment period, the breakeven point will occur at 7 years and 4 months. If you were to sell the property prior to the breakeven, the ARM would produce a lower cost of housing.
One of the benefits for lenders making adjustable-rate mortgages is that they have less risk because the yield can change to reflect the current market. Most ARMs must adjust down as well as up which means if rates do come down, the buyer can continue with the ARM at a lower rate or convert it to a fixed-rate at the, then, current rate.