Adjustable-rate mortgages are staging a comeback, but is it the Great Recession all over again?

In fact, the number of ARM applications per week has grown over 70% since January.

While the prevalence of ARM loans is significantly below pre-crisis levels, the new surge raises fresh questions about whether Americans have learned from the past or are taking risks that may backfire.

Buyers seek relief from housing costs

It’s no surprise why buyers are flooding into adjustable-rate mortgages now.

Mortgage payments are on average more than $300 higher in 2022 over previous years, in part because of higher rates on 30-year mortgages, according to the Federal Reserve Bank of Atlanta.

The median American household used up 38.6% of its income to make its mortgage payments in March, the bank reports, up from 30.2% in March 2021. That’s the biggest share since August 2007.

ARMs are popular with buyers because they start at a lower rate than 15- or 30-year fixed-rate loans. As of June 9, rates for a 5/1 ARM averaged 4.12%, while fixed rates for 15- and 30-year loans were at 4.38% and 5.23%, respectively.

But after an initial period of 3, 5, 7 or 10 years, the interest rates on ARMs begin resetting annually, based on existing market levels. That means the monthly payment can rise or fall, sometimes dramatically.

History has shown how that can catch people by surprise — and the consequences of that mistake.

Financial Crisis remains front of mind

With the Federal Reserve pushing back hard against inflation, buyers can expect interest rates to rise for some time.

“We as brokers and lenders should be looking for sustainability for our clients,” says Linda McCoy, president of the National Association of Mortgage Brokers.

“We saw what happened in the past and do not wish that on anyone. Buyers are so happy when they move into their new home, and we want them to be able to stay there.”

During the subprime mortgage crisis that lasted from 2007 to 2010, many buyers overbought and banks overlent — largely on the backs of low-rate loans that lured borrowers with poor credit into homes they couldn’t afford.

Once the fixed-rate periods ended and loans reverted to existing market rates, many homeowners saw monthly payments skyrocket even as their home values sank drastically.

“It was a very sad time, especially for those who had those 2/1 buydowns,” McCoy says, referring to the financing strategy that offers only two years of stability before the rate resets.

The loans, which are still available today, typically feature rates that are two percentage points lower than conventional loan rates during the first year and one percentage point lower in year two before the rate resets.

”They were fixed for two years and then started going up every year, and housing values had plummeted so they could not refinance. It was a disaster for all involved from the homeowners, lenders, servicers, brokers, bankers and all businesses that supported the industry,” McCoy says.

ARMs can be used responsibly

Does the surge in ARM loans suggest we’re headed for a repeat crisis? Probably not.

The current pace of applications for ARMs, while surging in recent months, remains well below its long-term average and more than 80% below its peak between 2003 and 2006, says Joel Kan, the Mortgage Bankers Association’s associate vice president of economic and industry forecasting.

“This is a very different environment than the products prevalent prior to the Great Financial Crisis,” Kan says. “The credit quality of borrowers is stronger, and the types of ARMs that are available now are of much lower risk, without the same potential for near-term payment shock.”

Buyer preferences appear to be changing, too. More than two-thirds of ARM loan applications in recent months have 5-, 7-, or 10-year fixed periods, allowing borrowers more time to benefit from a fixed, lower rate and providing more time to build equity in their homes, Kan says.