Perhaps a good place to start is to understand what an Adjustable Rate Mortgage is and why you might consider one? “ARM” loans, as they are commonly known, are a hybrid loan that employs a fixed rate for a predetermined period. That can be 3 years, 5 years, 7 years and even as long as 10 years. Once the fixed period is over, the loan then “Adjusts” based on a market indicator like LIBOR, usually once a year.
For some, ARM-type loans are an ideal product. They fit short term goals nicely, if your plan is to sell your home inside of one of the predetermined periods. ARM-type loans are also a great fit for folks that want to stretch their hard-earned dollars further or increase their buying power. This can be especially true for borrowers here in the San Francisco Bay Area where FHA Loan Limits are at their highest but property prices are much higher. The ceiling for conventional loans was recently raised to $679,650, as of January 2018 but again, conventional loans are simply not large enough for most purchases in this market. So, if you are searching for a home loan and with rates on the rise, an Adjustable Rate Mortgage might be in order.
Here’s some support for an adjustable rate mortgage. While we have been enjoying an historically low target federal funds rate, the March 2018 target federal funds rate increase could wind up impacting your affordability. What does that mean? Basically, for every quarter point increase in your mortgage interest rate, your monthly payment increases, which results in a small loan amount. Huh? Yeah, I know. Here’s a quick example:
Say you are looking to purchase a home for $1,250,000. Your 20% down payment ($250,000) results in the need for a loan of $1,000,000
Under the fixed rate scenario in the right column, your payment is $221 more per month—significant over the life of the loan, right? The bigger issue is if that extra $221 per month pushes you over bank’s the DTI cap or you simply cannot afford an additional $221 added to your monthly budget. If either of these are true, you’ll need to either come in with a larger down payment or get a smaller loan. This could result in you not being able to afford that home you really want.
Let’s make that real: to keep your payment the same at the 30-year fixed rate of 4.5% (4.524% APR), as it would be under the 7/1 ARM rate of 4.125% (4.585% APR), you’ll only be able to borrow $957,000. See how that works? Affordability due to a lack of inventory is already a real issue here in the SF Bay Area. With inflationary pressures and continued movement by the FOMC to minimize said inflation through increasing the target federal funds rate, mortgage rates will impact affordability even more so.
Lest there be any question about what affordability means, the US Department of Housing and Urban Development (HUD) over time has set a 30 percent threshold for owner-occupied housing, and it remains the indicator of affordability for housing in the United States. This means those spending more than 30% of their household income on their housing costs are considered to housing cost burdened.
Here comes the tough part; some believe that increasing mortgage rates will ease the affordability issues we’re facing here in the SF Bay Area by putting downward pressure on prices. Unfortunately, according to a recently published paper by Freddie Mac this is not the case. In that study, they note that in 1993/1994 when mortgage rates spiked 2.4%, housing prices continued to increase by 3%. Mortgage originations and housing starts on the other hand dropped by as much as 13%. So, the effect of increasing rates truly falls to the borrower and the overall economy. Either borrowers put the purchase on hold and continue to rent or they look at lower priced homes—something that isn’t very reasonable here in the inventory strapped SF Bay Area. Look at the graphic above for the results of that study.
Let’s dig a little deeper on that to understand how the pieces come together. Your ability to repay relies, in part, on your debt-to-income (DTI) ratio. As your monthly payment goes up, so too does your DTI. (When I cover Fannie Mae’s Loan Level Adjusters, we’ll go over the other factors). As your DTI increases, something must give. This typically means a lower loan amount, which should keep your monthly payment the same or similar. ARM rates, generally, are lower than 30 Year Fixed Rate mortgages, so going with an ARM can help you stay on track with the loan amount that helps you win the purchase.
So where is the pressure coming from on interest rates in general, you ask? Unemployment is down, nearing record lows and inflation remains relatively high. Raising the prime rate is just one way for the Federal Reserve to ensure that it is doing its part to keep inflation at bay while keeping the economy humming along.
So, the real question is: Should you go with an ARM loan or a traditional 30-year fixed loan? Only you can answer that question. However, here is some food for thought as you mull over your decision. 30-year fixed rate mortgages are resetting to their highest levels since January 2014. Still, these rates are historically low. If you are looking to purchase a home, ARM-Type loans are pricing at slightly lower rates for 3/5/7/10 years. FYI, 7/1 ARM products tend to be the right fit for most, but everyone’s circumstances are unique, so talk to your mortgage professional to get information that meets your specific situation. Better yet, call me.