Over the past two years, interest rates have risen from historical lows to as high as 7% for 30-year fixed-rate mortgages. Interest rates have remained elevated at levels that haven’t been seen for nearly 20 years. According to recent CFPB analysis of quarterly HMDA data, these higher rates have already led to increased monthly payments and higher debt-to-income ratios for mortgage borrowers.
In response to the increasing mortgage interest rates, financial service providers are marketing alternative financing options that may offer opportunities for consumers to access lower rates in this relatively high interest rate environment. Providers may also be offering products such as cash out refinances that can be costly to consumers when they replace an existing low interest rate mortgage with one at a higher current rate. If you’re considering one of these mortgage products, you’ll want to look at it closely to understand the risks and whether it meets your needs.
Below we discuss some of the more common product options being offered.
Alternative Mortgage Products
Adjustable-Rate Mortgages (ARMs). While the overall market for mortgages has declined, ARMs have increased from less than 5% of mortgages in 2019 to around 10%. ARMs typically have a fixed interest rate in the beginning and then adjust annually or every six months. For example, a 5/1 ARM has a fixed interest rate for five years and then adjusts every year for the rest of the loan. As the above chart shows, the initial rate for ARMs is almost always below that of a comparable fixed-rate mortgage, sometimes substantially so.
Consumers may be wary of ARMs because of their role in the housing crisis and 2008 recession. However, while these products are not risk-free, ARMs today look very different than those of the earlier era. Before the 2008 recession, many ARMs had fixed-rate periods of three years or less. Today most ARMs have fixed periods of five, seven, or even 10 years.
During the fixed period, the interest rate won’t change even if market rates go up, providing stability for homeowners during this time. And most ARMs today, in accordance with federal law, take into account the maximum payment in the first five years in assessing “ability to repay.” As a result, today’s ARMs are much less volatile than the ARMs made in the years leading up to the Great Recession, and thus much less likely to lead to payment shock.
Thus, ARMs may provide a good option for certain consumers by offering a lower interest rate as compared to a fixed rate mortgage while providing initial rate stability. For consumers planning to sell their home during the fixed period an ARM may work well by providing rate stability during the time the consumer expects to keep the loan. The longer fixed-rate period may also give consumers more time to refinance if rates fall in the future. However, borrowers may find themselves facing higher payments after the fixed-rate period ends.
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