In this episode of the REconomy Podcast™ from First American, Chief Economist Mark Fleming and Deputy Chief Economist Odeta Kushi explain why the recent increase in adjustable-rate mortgages (ARMs) does not necessarily signal an impending housing bust.
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Listen to the REconomy Podcast™ Episode 39:
“Borrowers are switching to ARMs for a lower mortgage rate to try and keep monthly payments the same, even as rates rise. And in the latest data from the Mortgage Bankers Association's weekly mortgage application survey for the week ending May 13th, the ARM share of mortgage activity was just over 10% of total applications. This may seem small, but it's significantly higher than at the beginning of the year when that share was just over 3%. In fact, the share is near its highest point since 2008.” – Odeta Kushi, deputy chief economist at First American
Odeta Kushi - Hello, and welcome to episode 39 of the REconomy podcast, where we discuss economic issues that impact real estate, housing and affordability. I am Odeta Kushi, deputy chief economist at First American and here with me is Mark Fleming, chief economist at First American. Hey Mark, can you lend us your wisdom today?
Mark Fleming - Hi, Odeta. Apart from suggesting something about my age, sure, what kind of wisdom would you like me to impart?
Odeta Kushi - There's actually a clue in my question, lending wisdom, of course. Specifically, the different types of mortgages consumers can use and their differences. This is especially important today because potential home buyers are being squeezed by rising mortgage rates alongside rising house prices, and different mortgage products can make a big difference in the monthly payment. So today, in particular, the very popular 30-year, fixed-rate mortgage versus an adjustable-rate mortgage is what we'll be discussing. And that adjustable-rate mortgage is also known as an ARM. But, before we jump into the details, let me just define what a fixed-rate mortgage is versus an adjustable rate. It's actually pretty straightforward. A fixed-rate mortgage is a mortgage loan where the interest rate on the loan remains the same throughout the term of the loan. In this case, it's 30 years, as opposed to loans where the interest rate may adjust. As a result, payment amounts for a fixed-rate mortgage in the duration of the loan are fixed and the person who is responsible for paying back the loan benefits from a very consistent payment. But Mark, can you talk a little bit about the history of mortgages in the U.S.?
Mark Fleming - Yes, my favorite part of every podcast episode is the walk down history lane, so I'm happy to do it. The history of mortgages in America could probably be its own podcast episode, or even a series of podcast episodes to really get into it. But the brief high-level overview is this. A typical mortgage in the early 1900s might have had a term of five years, required a 50% down payment...
Odeta Kushi - Whoo, wow.
Mark Fleming - Exactly, now you can get 3% to 5% down, such a difference. Loans typically had a balloon payment for the entire principal at the end of the term and we're often even callable, meaning the lender could ask to get their money back and be repaid in full at any point, even before the term was up. Lots and lots of certainty for the borrower, he says sarcastically. This sort of worked until the Great Depression hit and the banks stopped lending. But what do you do if your loan was about to come due, or was being called early by the lender? Either you could pay the balloon payment, with all that money in your savings account... Exactly...and own the home outright, or get a new five-year loan to pay off the ballooning loan, aka the early 1900s version of a refinance. But wait, lenders aren't lending. So the only option there would be default and foreclosure. This was obviously not good for the stability of the housing market. And so the U.S. government created the Homeowners Loan Corporation in 1933, the Federal Housing Administration, aka FHA in 1934, and the Federal National Mortgage Association, aka Fannie Mae, in 1938. These entities promised to buy loans and the risk associated with them from the banks, so they would keep lending. If you've ever watched, 'It's a Wonderful Life' at Christmas time. This is kind of what we're talking about, recirculating the money back to the lender so he can keep making more loans. And along with those new entities, the 30-year, fixed-rate mortgage was created. Not only a much longer term, and a fixed rate, but also no longer callable, no longer balloon payments at the end of the term, so it was great for the consumer. In 1970, Congress added Freddie Mac to the mix. Freddie, like Fannie, purchased mortgage loans from lenders and either held them in their portfolio or later resold those loans to investors. That's what we call today mortgage-backed securities or MBS. In the 1980s, adjustable-rate mortgages were added. They were still typically 30-year terms, without callability or prepayment penalty, and also were usually fixed-rate in the early years. Have you heard of a 3, 5, 7 or 10-year hybrid ARM? Because the rate wasn't locked in for all 30 years, these mortgages typically had lower rates than the 30-year mortgage at the same time, and they would allow borrowers to benefit from interest rate fluctuations, when rates fell by adjusting the loan rate down through the loan term as rates were falling.
Odeta Kushi - More sarcasm. That was a pretty good summary and you even got to talk about your favorite decade, the 80s. You snuck that in there.
Mark Fleming - Haha, exactly.
Odeta Kushi - But isn't the opposite also true of ARMs? That when rates rise, the borrower is on the hook to pay more.
Mark Fleming - Right you are. A one-sided benefit because when rates go up on the other side, the monthly payment on that variable-rate loan also goes up when it's not in that fixed-rate period. But over the last 30 years, except for the last few months, of course, the trend in the long-run has most often been declining rates, not rising rates. So, at least in hindsight, that rising payment risk for an ARM loan has been low. But ARMs have such a bad rap today, as they are the symbol of the last housing market crash. And now they're making a comeback. And one has to wonder if that's a sign of an impending bubble bust again. Because if arms were associated with bubbles busting before, is that the case again?
Odeta Kushi - Yeah, so why would that be? Why do ARMs have such a bad rap? And also, why are they coming back?
Mark Fleming - Well, ARMs were popular prior to the crash. And back then, many ARMs had very short, typically two- or three-year fixed-rate periods. They had higher lifetime cap, which is how much the interest rate can increase in total. In other words, bigger payment shocks. They had additional monthly payment-reducing features, the objective being to be able to lend money at a consistently low monthly mortgage payment rate, even though house prices kept going up. These features were things like negative amortization, initial teaser rates, or not even requiring documentation of assets or income and the ability to pay. So pre-crisis ARMs, they incentivize the homeowner to sell and refinance quickly before you ever got to the end of that fixed period, instead of actually going into that variable rates segment once the fixed-rate period ended. But these are not your parents ARMs of old. These are fundamentally different from those ARMs that were originally created in the 1980s, with all of that, shall we say, financial innovation built in during the housing boom.
Odeta Kushi - And that's just not the case today, because today, regulations established after the housing market crisis discourage those pre-crisis style ARMs. Instead, borrowers today can choose from arms with 3, 5, 7, and even 10-year fixed periods, which offer lower interest rates than the traditional 30-year, fixed-rate mortgage. The regulations that ARMs must adhere to today include parameters that actually help protect a consumer's ability to repay the loan. But we said that ARMs are making a comeback today. Why is that the case?
Mark Fleming - It makes perfect sense that ARMs are making this comeback because when mortgage rates rise, as they're doing in today's housing market environment. ARMs typically have a lower rate than the 30-year, fixed-rate mortgage. Lower because the borrower is essentially taking the risk of higher rates over the majority of that 30-year term when it comes out of that fixed period on the ARM loan, instead of the mortgage investor who's promising that your payment will never change for the next 30 years. So, it's who is taking that interest rate risk that is fundamentally different. And because the borrower is taking that interest rate risk, they get to pay a lower monthly payment. So, in order to maintain your house-buying power, you switch from a fixed-rate mortgage to an ARM.
Odeta Kushi - Ah, so borrowers are switching to ARMs for a lower mortgage rate to try and keep monthly payments the same, even as rates rise. And in the latest data from the Mortgage Bankers Association's weekly mortgage application survey for the week ending May 13th, the ARM share of mortgage activity was just over 10% of total applications. This may seem small, but it's significantly higher than at the beginning of the year when that share was just over 3%. In fact, the share is near its highest point since 2008.
Mark Fleming - And you know me, I'm not exactly a fan of this idea of us being particularly rational individuals. But, in this case, it's actually very rational. In that same report, we found that the average contract interest rate for the 30-year, fixed-rate mortgage was 5.5% in the week ending May 13. I am rounding up one decimal point, while the average contract interest rate for the 5-1 hybrid ARM, meaning five years fixed, was 4.42%. Fully a percentage point lower. And, by the way, in a 5-1 ARM, the five, as I said, specifies how long it's fixed. And the one is the indication of how often that rate adjusts once the fixed-rate period of the loan is over. In this case, once every year.
Odeta Kushi - Wow. So, if we take the average household income at those rates that you just mentioned, an ARM actually increases consumer house-buying power by approximately $47,000, compared with the traditional 30-year, fixed-rate mortgage. But, if maintaining house-buying power is a benefit of ARMs, is there a risk?
Mark Fleming - Yes, the old economics phrase, there's no such thing as a free lunch, comes to mind. It's really about the fundamental difference between an ARM and a fixed-rate mortgage, which has to do with who's covering that interest rate risk in the variable period. And when that borrower might be quote, "exposed," back to the market rates.
Odeta Kushi - Let's explain what you mean by exposure to market rates. While your mortgage payment may be lower and unchanging over the fixed-rate period, monthly payments could change for better, or worse, once that fixed period ends. There are initial caps on today's ARMs, which means that there is a limit on the amount the rate can adjust upward the first time the payment adjusts. There are also caps on today's ARMs, limiting subsequent adjustments as well. And finally, there are lifetime caps, which are most commonly five percentage points.
Mark Fleming - But how much the mortgage rate may change once the fixed rate period ends may, for many, just be a moot point. The reason is because most first-time home buyers don't jump right into their forever home. I didn't. Odeta, I know that you may be hoping to. But, even the second- and third-time buyers, it's not their forever home. Our tenure data actually suggests that the average amount of time people live in a home is just over 10 years right now and it has been going up, but that's the average. So many stay put for much less time than that.
Odeta Kushi - So, if you're a first-time buyer that will likely move out of your starter home in the next three to seven years, then there is not much benefit from paying the premium on the fixed-rate mortgage for all those extra years that one is unlikely to use.
Mark Fleming - All right, but have we seen this before, Odeta?
Odeta Kushi - Absolutely. For example, back to your favorite decade in the 80s, when mortgage rates were much, much higher than today. Many buyers took advantage of ARMs. The higher the mortgage rates in general, the bigger the benefit relative to the risk.
Mark Fleming - And it's no surprise again that we see increased interest in ARMs today as borrowers seek ways to maintain their house-buying power. And because today's ARMs are not your recession ARMs of old, they're not necessarily indicative of an impending bust.
Odeta Kushi - That's right, and as long as the spread between ARMs and fixed-rate mortgages continues, first-time home buyers or those with short-term tenure expectations may choose ARMs because the lower rate allows them to maintain a monthly payment, knowing that they will likely sell before the mortgage ever becomes adjustable. All right. That's it for today. Thank you so much for joining us on this episode of the REconomy podcast. If you have an economics-related question you'd like us to feature on a future episode, you can email us at email@example.com. We love to hear from our listeners. And if you can't wait for the next episode, you can follow us on Twitter. It's @OdetaKushi for me and @MFlemingEcon for Mark. Thanks and until next time.
This transcript has been edited for clarity.