Home ownership

With the Federal Reserve hinting it may soon begin to boost short-term interest rates, will borrowers turn to ARMs to keep enjoying the rock-bottom mortgage rates they’ve grown accustomed to?

“Not in a big way,” said Ken Maes, an executive with Skyline Home Loans NW. “ARMs still have a negative perception.”

Maes and other mortgage professionals said they don’t expect to see a surge in ARM applications anytime soon. He noted that while initial rates on ARMs currently run about half a percentage point lower than on 30-year fixed-rate mortgages, it’s not a big enough difference for them to grab a big share of newly financed home loans.

“Caution is still the word of the day,” he said.

ARMs were a hot item a decade ago, accounting for as much as one-third of purchase mortgage applications during the years of the housing bubble, according to figures from the Mortgage Bankers Association (MBA). But a lot of those borrowers got burned when their loans reset and their payments jumped to unaffordable levels.

Today, ARMs account for only about 1% of mortgage applications for home purchases, according to the MBA. That’s largely because the rates on fixed-rate mortgages are so low that ARMs just don’t offer much of an advantage, but many people also remain leery of ARMs after the experience of the last decade.

“ARMs have gotten a really bad reputation throughout the financial crisis,” said Dave Jacobin, president of 1st Mariner Mortgage. “People have unfortunately been a lot more reluctant in the past to go down that road and choose an ARM, when in a lot of cases it’s actually a better plan.”

He expects that any increase in short-term rates that the Fed might make will be subtle, around a quarter of a percentage point, which would have a fairly minor effect on mortgage rates. He doesn’t think the Fed would risk triggering inflation with a bigger increase and expects that long-term rates will likely stay the same or perhaps even drop a bit.

“It could increase the amount of people choosing ARMs, but by no means is it going to skyrocket,” he said.

Jacobin describes himself as a “big believer” in 5-, 7- and 10-year ARMs, which he says give borrowers plenty of time to prepare for the eventual rate adjustment at the end of that period. Such loans are often useful for borrowers who don’t expect to remain in a home for a long period of time and won’t benefit from locking in a rate for 30 years.

“It’s really about best fit for the client,” said Josh Moffitt, president of Silverton Mortgage Specialists, Inc. “If their plan is to be in a home for five years and sell, then either a 5-year or a 7-year ARM might be worth considering. Currently the spread between fixed and adjustable isn’t that great though, so the decision becomes about risk vs. reward.”

Moffitt said borrowers can use the adjustment limit on an ARM to determine the maximum their rate could increase when the loan resets (many ARMs during the bubble years had large rate increases practically built in, which is how many borrowers got into trouble). They can then use that to determine how quickly an increase might offset the savings you’d realize from an initially lower rate.

“If a client can save $200 a month in an ARM product that resets in five years, they will have saved $12,000 ($200 times 60 months),” he said. “The ARM has an index and margin set within the parameters of the note, and based on that, you can predict what is the ‘worst case’ in Year 5 and moving forward.”

In most worst-case scenarios, it would take a year or two for a rate adjustment to offset the savings realized during the initial years of an ARM, Moffitt said. Of course, if the rate adjusts less than the maximum, the borrower would continue to see the savings for a longer period of time.

For some borrowers, an ARM might already make sense even without an overall rise in mortgage rates, according to Amy Tierce, a regional vice president with Wintrust Mortgage.

“Jumbo borrowers often prefer long-term ARMs which are fixed for 5, 7 or 10 years and then become adjustable,” she said.

Tierce said she sees ARMs already gaining in market share, but thinks fixed rates will likely have to move into the high-5% range before they really start to take a sizeable chunk of the market.

“It is important to remember sub-5% rates still are considered historically low,” Tierce said. “Conservative consumers like fixed rates, even when they believe that they may not remain in the property for the long term.”

In order to have access to the lowest mortgage rates available, consumers will also need good to excellent credit (here’s a guide to what’s considered a good credit score). Prior to shopping for a mortgage and a home, consumers may want to check their credit to see where they stand, and determine if they want to take time to build their credit before they apply for a mortgage. You can get your credit reports for free once a year from each of the major credit reporting agencies, and there are many ways you can get your credit scores for free, including through Credit.com.

This article originally appeared on Credit.com and was written by Kirk Haverkamp.