Bay Area adjustable-rate mortgages return as interest rates rise

New rules have also made it much harder to qualify for an ARM, and their initial discount compared to fixed-rate mortgages has not been compelling.

With a fixed-rate mortgage, the rate is fixed for the life of the loan, giving borrowers the security of a stable payment.

With ARMs, the rate and monthly payments are typically fixed for a certain number of years, then go up or down periodically in line with market rates – subject to certain limits. A loan that is fixed for five years, then adjusts every year thereafter, is known as a 5/1 ARM. If it’s fixed for seven years, then adjusts every six months, it’s called a 7/6-month or just a 7/6 ARM.

 Bay Area adjustable rate mortgages return as interest rates rise

Donna Weber, left, and Ed Roseboom, right, prepare dinner at their home in Fairfax, Calif., on Tuesday, October 18, 2022. Donna Weber and Ed Roseboom sold their Palo Alto condo and bought a restored craftsman home in Fairfax, and their mortgage broker encouraged them to take out a 7-year Adjusted Rate Mortgage.

Salgu Wissmath/The Chronicle / The Chronicle

ARMs got started in the early 1980s when mortgage rates were in the teens. They’re more common in high-priced areas. The metro areas where ARMs had the largest share of conventional mortgage originations in January and February were San Jose, Bridgeport, Conn., and San Francisco, according to CoreLogic. But they’re not for everyone.

If you’re considering an ARM, it’s important to know how they work.

The interest rate on an ARM is made of two parts: an index, which changes over time, plus a percentage or “margin” that remains fixed for the life of the loan.

Many ARMs today are indexed to the Secured Overnight Financing Rate, which replaced the London Interbank Offer Rate following a scandal over LIBOR.

Suppose you take out a 5/6-month ARM indexed to SOFR with a 2.25% margin, and SOFR is 3%. Your “fully indexed” rate is the index when the loan is made plus the margin, or 5.25%.

Your starting rate, fixed for five years, is the “note rate.” It could be higher or lower than the fully-indexed rate. At the five year mark, the rate and your payment will adjust – up or down – to SOFR on that date plus 2.5%.

ARMs are generally subject to three rate-adjustment caps. A 2/1/5 cap, for example, means the rate can’t change by more than 2% at the first adjustment period, by 1% at each subsequent adjustment and by 5% over the life of the loan. Rates generally cannot fall below the margin, in this example 2.5%.

These details are in the “Loan Estimate” borrowers get when they apply for a mortgage.

- Kathleen Pender

When Victor Galvez and his wife sold their home in the outer Sunset and bought one in Long Beach, they chose a 30-year fixed-rate loan. “I wasn’t too excited about adjustable mortgage rates. I wanted to have better continuity,” he said. Plus, when they locked in a rate of 4.65% in mid-August, adjustable rates didn’t seem much lower. By the time they closed on their Long Beach home in September, fixed rates had risen by a full percentage point.

ARM rates typically start out lower than fixed-rate mortgages, so payments are initially lower. How much lower changes frequently and depends on the type of mortgage.

As of Tuesday, the average rate on a 30-year fixed-rate conforming loan was 7.15% versus 6.35% on a 5/1 ARM, a difference of 0.8 percentage point, according to trade publication Mortgage News Daily. At the end of December, both rates were around 3%.

Some people choose ARMs because they think interest rates will fall and they can refinance into a fixed-rate loan – or they plan to sell their home – before the first rate adjustment. In the meantime, they can enjoy the lower payments.

In the past, some chose ARMs because they could borrow more than they could with a fixed-rate loan. This helped prop up home sales and prices when interest rates rose. But this is not necessarily the case today, because it has gotten harder to qualify for some ARMs. “Underwriting is a lot more stringent,” said Joel Kan, deputy chief economist with the Mortgage Bankers Association.

As of last week, almost 12% of all mortgage applications were for ARMs, according to the association. That’s up from 3% at the start of the year, but their current share is far below the levels reached in late 1994, early 2000 and mid-2004 to mid-2005, when ARMs accounted for more than a third of all applications.

Separate data from BlackKnight show ARMs reaching 40% of loan originations, and 50% by dollar volume, in 2004-05. But today’s ARMs are downright sober compared to the ones being peddled in the maniacal years leading up to the mortgage meltdown in 2008.

 Bay Area adjustable rate mortgages return as interest rates rise

Donna Weber, left, and Ed Roseboom, right, relax on the couch at their home in Fairfax, Calif., on Tuesday, Oct. 18, 2022. Donna Weber and Ed Roseboom sold their Palo Alto condo and bought a restored craftsman home in Fairfax, and their mortgage broker encouraged them to take out a 7-year Adjusted Rate Mortgage.

Salgu Wissmath/The Chronicle / The Chronicle

In that era, ARMs often came with an introductory or “teaser” rate that lasted only a year or two before adjusting. Lenders could qualify borrowers based on those initial rates. Many ARMs in this era were issued to borrowers with subprime credit scores and required little or no down payment or proof of income and assets. Many offered the option of paying interest only – and in some cases not even the full principal payment – for a number of years. These loans were packaged into pools and sold to investors. When some started defaulting soon after origination, it caused a ripple effect that helped bring the financial system to its knees.

Since then, rules have changed. The Dodd-Frank Act requires lenders to make a “good faith effort” to make sure all borrowers have the ability to repay. This rule applies to virtually all loans whether they are fixed or adjustable, conforming (meaning they can be guaranteed by Fannie Mae or Freddie Mac) or non-conforming (includuing jumbo loans, which exceed $970,800 in most Bay Are counties).

When lenders make what’s known as a “ qualified mortgage,” it’s presumed they complied with this rule. A qualified mortgage can not have interest-only payments, negative amortization (where unpaid principal is added to the loan balance), terms longer than 30 years or fees that exceed a certain limit. The lender must verify the borrower’s income, assets and employment.

The lender also must qualify the borrower based on the highest rate and monthly payment that could apply during the first five years. That’s why you rarely see ARMs shorter than five years.

Lenders can still make loans that don’t meet the definition of a qualified mortgage, but they can’t be sold to Fannie or Freddie, so they’re taking on more risk. Typically these “non-qualified mortgages,” such as interest-only ARMs, are made only to highly qualified buyers. The vast majority of all home loans, including jumbos, are qualified mortgages.

When Donna Weber and Ed Roseboom sold their Palo Alto condo and bought a home in Fairfax, their mortgage broker encouraged them to take out a 7-year ARM, “which I was really not into at all,” Donna said. But the loan had a start rate of 4.875%, which as Donna recalls was about 1 percentage point lower than the fixed-rates at that time, in mid-June.

They were thrilled to get the Fairfax home for less than the asking price, which had already been reduced. But they couldn’t sell their condo before they closed on the new home in mid-July. “It took us five weeks. We got one offer under asking, and a big part of that was the mortgage rates,” Donna said.

When the condo sold, they were allowed to “recast” their loan, reducing the balance by about half, which is one reason they chose that mortgage. When you recast, you make a lump-sum payment toward the principal. The lender reduces your payments but the rate and term remain the same. The recasting fee was just $250.

Beth Phoenix, on the other hand, locked in a rate of 5.625% on a 30-year fixed-rate loan when her offer on a home in San Mateo with an in-law unit for her daughter was accepted two weeks ago. She had enough savings for a large down payment and didn’t need an ARM to qualify.

“I don’t have any interest in an adjustable-rate mortgage because who knows what’s going to happen with mortgage rates. And given that I’m going to retire in a couple years, it did not seem like a wise idea,” she said. “It seems like ARMs are mostly useful for people who are a little younger, don’t have a big down payment, but whose earnings capacity is expected to go up. They can get into a house at a fairly affordable rate and by the time the rate adjusts, presumably they will have more assets. That’s kind of the opposite of my situation.”

But talking to young home buyers about ARMs “is very, very hard,” said Michael Bellings, a Compass real estate agent in San Francisco. “All these Millennials grew up in an environment of really, really low rates. They think, ‘Oh my God, once my fixed rate is up, I’m at the mercy of the economic index.’”

Keith Gumbinger, a vice president with mortgage website, said young buyers “may have seen their parents or friends of their parents get into ARMs that didn’t work out for them,” he said. “It wasn’t the ARMs themselves that were dangerous. It was the layering on” of risky features that blew them up.

There’s another reason ARMs are lagging in popularity. Fixed-rate mortgages tend to follow the 10-year Treasury yield while ARM rates follow shorter-term yields. Normally short-term yields are less than long-term ones, but in recent months, two-year Treasuries have yielded more than the 10-year. Because of this anomaly, investors aren’t eager to buy ARMs and lenders aren’t eager to make them, said Gunnar Blix, Black Knight’s director of housing markets research.

It’s also why ARMs haven’t been offering much of a discount to fixed-rate mortgages, although that’s starting to change and may cause more borrowers to embrace ARMs.

“Year to date, most of my clients have applied for 30-year fixed mortgages, with the plan to pay discount points (an upfront fee) for a lower rate,” said Westin Miller, branch manager with Pinnacle Home Loans in Santa Rosa. However, “the pricing spread between ARMs and fixed-rate mortgages has recently widened in favor of ARMs. I suspect more ARM originations in the months to come.”

A rush to ARMs, if there is one, “will not be a contributor to unsustainable pricing or unqualified borrowers getting into homes like we saw prior to the housing bubble,” said Greg McBride, chief financial analyst with

For borrowers, an ARM could make sense “if you expect your earnings to accelerate rapidly in the years ahead, such as a doctor or lawyer building a practice,” said Greg McBride. “But it’s not a risk most borrowers should take.”

If you can’t afford a home with rates and prices where they are now, “be on the sidelines saving for bigger down payment,’ said Dean Wehrli, principal with John Burns Real Estate Consulting in Sacramento. “The higher the down payment, the lower your monthly payment.”

Kathleen Pender is a freelance writer and former columnist for The San Francisco Chronicle. Email: Twitter: @KathPender

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