Rising Home Prices lead to many ARM Applications

Home prices are on the rise, and potential buyers are getting creative with ways to finance their home purchases. According to research firm Inside Mortgage Finance, the number of adjustable-rate mortgage (ARM) originations rose by over 40 percent from the first quarter of 2017 to the second quarter. ARMs typically have a fixed period of at least five years, and then the rate has the possibility to change after that. Introductory rates for ARMs are usually lower than for fixed-rate loans, but ARMs are still subject to more risk than a traditional 30-year fixed mortgage.

According to the Mortgage Bankers Association, the average conforming 30-year fixed mortgage rate was 4.11% as of last week. The five-year ARM averaged 3.38%, but will either increase or decrease upon the end of the fixed period, depending on market conditions.

Spring is the busiest season for home buying, so it stands to reason that ARM demand usually rises from the first quarter to the second. Families dominate the housing market during this time, usually looking to buy the largest homes available. A 40% jump is remarkably high, though; spring 2016’s AMP jump was only 15%. This could indicate that buyers in 2017 don’t have as much financial strength as in years past, and are looking for a lower-priced financing option.

Mortgage rates remain very low, especially when considering rates from decades past, but they are slowly making their way upward. Since the last financial crisis, most home buyers have favored the stability of the 30-year fixed rate mortgage, but this is changing due to consumers opting for less expensive options.

Although increases have flattened recently, home prices have been trending upward for three years now, and they appear to have picked back up on that trajectory. The average home price in the U.S. rose 6.9% from August 2016 to August 2017. That’s the biggest gain in three years. July’s annual gain was 6.7%.

Although home prices have been rising faster than inflation, CoreLogic chief economist Frank Nothaft predicts the gains will actually slow down next year if mortgage rates rise, which he expects them to do. Nothaft predicts this will be the tipping point for demand, although others think that the low supply of available properties, especially on the low end, will keep prices high in spite of rising rates.

Relative to income and employment growth, prices are being driven up already, with close to half of the nation's top 50 housing markets being overvalued, notes Matthew Pointon, property economist at Capital Economics. The amount of existing homes for sale is at an all-time low, so potential buyers are having to offer more than they would under more normal market conditions.

According to Pointon’s calculations, home prices should be rising by more than 10% - far higher than their current growth rate. He thinks tight supply would dictate this if not for very tight mortgage lending standards.

"Cautious appraisals are preventing desperate buyers from bidding too much for a home, as are strict debt-to-income ratios," he said.

ARM loans are often blamed as a major contributor to the major housing crash that happened in the late 2000s, but currently offered ARM products are nothing like those of yore. Extremely risky products such as negative amortization loans no longer exist. These types of ARMs offered attractively low introductory rates, but the lender would recoup the savings by adding the savings amount onto the loan itself.

Nowadays, lenders are subject to extensive disclosure requirements, ensuring that borrowers understand fully the type of loan they are applying for. In particular, the borrower must be advised that their introductory rate is only effective for a limited period, and it can go upward or downward after that. Modern loans also must be documented and underwritten for the full length of the loan term, ensuring that the borrower can afford the mortgage payment for not just the introductory period, but for the life of the loan. That, too, is a new development. Potential applicants for ARMs may be wooed by the rates, which appear lower on the face, but it is imperative that they understand what they are applying for. Borrowers and lenders both have an obligation to ensure that suitable loans are being made.

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