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Every week, data is put out about
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mortgage applications. It gives us a
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sense of how busy the market for a new
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mortgage or a refinance mortgage is. As
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part of that data, we are finding out
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the numbers of people who want a
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traditional mortgage with a lockedin
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rate or those people who would like to
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go the way of an adjustable mortgage or
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an ARM. Recently, activity around ARMS
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has been on the rise. Those mortgages
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tend to be riskier propositions for the
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homeowner due to how the rate can
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fluctuate. As to why this is going on
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right now, pleasure to be joined uh by
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Ben Keys, who is a Wharton real estate
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professor. Ben, great to talk to you
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again. How are you?
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>> I'm doing well. Thanks for having me,
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Dan.
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>> Okay, so is this a blip on the radar or
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the start of a trend?
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>> Well, I think this is a symptom of an
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incredibly expensive housing market
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right now. House prices are extremely
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high. mortgage rates remain
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frustratingly high and so for a lot of
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households looking to get into the
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housing market for the first time
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turning to an adjustable rate product
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can be a very smart choice to bring down
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costs
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>> and right and so when you go into an ARM
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is the expectation that you're doing it
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for a period of time you're not locking
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in an arm for a 15 or a 30-year period
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>> so there are a few different arm
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products out on the market and I think
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there is some confusion on exactly how
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they're designed. So, the most common
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products in the US housing market uh
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lock in your rate for a number of years
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and then they float thereafter. So, um
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they're often called a 51, a 71 or a 101
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product. And what that means is that for
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five years you have a fixed rate and
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then once a year thereafter the interest
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rate is going to change. And so what
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you're doing is you're kind of trading
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off some exposure to interest rate uh
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movement in the future, but you're
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locking in the rate for the short term.
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>> How much difference is there usually in
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the actual rate between an ARM and a
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traditional fixed rate mortgage?
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>> Well, it varies over time, but you see
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pricing differences anywhere from about
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50 basis points to a full percentage
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point uh cheaper mortgage if you're
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willing to take on some of that interest
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rate risk in those future years. How how
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frequently do you see people going the
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route of going with the ARM these days?
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>> So ARMs are still not all that popular.
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Um generally less than 10% of all
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mortgage buyers are taking on ARMS. Um
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you do see them uh a bit more popular in
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the jumbo market. So in the market of
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the most expensive homes uh that don't
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qualify for for Fanny and Freddy uh
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mortgage uh mortgage support. So within
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that segment, that's the segment where
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the interest uh payments are the largest
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and where there's there's the most to
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save um by going the adjustable route
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>> because of the market being the way that
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it is right now. You said it's probably
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not too much a surprise that we're
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seeing some of this activity at the
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moment because people are willing to I
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guess play the rate game here just to
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see if they can get a a lower rate for a
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period of time.
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>> Absolutely. I think it's it's useful to
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sort of think about this trade-off
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between the benefits and the costs of a
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of a product like this one. The benefit
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is obvious. You're going to save in
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terms of your interest payments for that
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fixed period of time, whether that's
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five, seven, 10 years. The cost is that
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when interest rates, you know, where
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interest rates are going to be at the
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end of that time period is up in the
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air. And so that's really the trade-off,
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the risk that you're exposing to. But I
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I think in the big picture, you know,
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actually it's it's a surprise that more
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people don't use these products. These
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are products where um they have a bad
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reputation because of things like the
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financial crisis. We can talk about the
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ways that those contracts were
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different. Um but these are actually
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pretty straightforward contracts. There
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are um a few aspects of them that you
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need to understand, but in that period
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of time, 5, seven, 10 years, you're
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going to save a considerable amount on
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your interest.
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>> Right. And as you mentioned, the
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perception of the arm uh has changed
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quite a bit over the last couple of
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decades.
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>> That's right. It it it's it's viewed, I
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think, still through the lens of 2008.
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And so there's a sense in which we tie
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all adjustable rate products to the
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teaser rates of of the subprime boom,
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the negatively advertising loans and the
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loans that had um these really sort of
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like exploding clauses in them, right?
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Where you'd see an a large jump in your
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payments when that expired. That's not
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what these products are. These products
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are locking in your rate for five,
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seven, or 10 years, and then thereafter
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they are going to fluctuate. It's
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important to understand how they
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fluctuate, what rate they're pegged to,
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and so on. But they are not a short-term
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exploding contract.
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>> But, but for those that don't
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understand, uh, you may, as you said,
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lock in that that lower rate for that
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period of time. What should their
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expectation be for that fluctuation on
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the back end of that that period of
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time?
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>> Yeah. Uh, so now we're getting to the
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risks. So, I think the I think the
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savings here are are very easy to convey
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relative to the 30-year fixed. You're
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going to pay less every single month in
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interest, but the risks are a little bit
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more opaque because who knows what
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interest rates will be, you know, five
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or 10 years from now. We can't predict
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where interest rates are going to be in
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a month or two. So, I I think what we
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need to do is is have a little bit of
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perspective and say, well, if rates come
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down, then you have the opportunity to
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refinance. So, on the downside, you're
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protected in that sense. you would
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refinance just as if you were
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refinancing out of a 30-year fixed. It's
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really on the upside where you face the
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dangers. And that's where you want to
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think about potentially refinancing into
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another adjustable rate product that has
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this hybrid feature where it pushes out
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the date further. Or we can think about
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who this product makes the most sense
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for. It's going to make the most sense
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for people who expect to move a
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refinance within 10 years. If you're in
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a starter home, you're pretty confident
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that in the next 10 years, you're going
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to be uh moving onward to maybe another
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job or a larger house to um fit a
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growing family, then why pay um to lock
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in an interest rate in the years that
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you're not going to be using the
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mortgage, right? So, most people don't
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stay in the same mortgage for 15, 20, 25
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years, and yet that 30-year fixed rate
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that you pay for that's rolling in that
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cost for all the years. So, I think
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that's really the trade-off
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>> of the different lengths of time that
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are available for an arm. Is one more
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attractive than the other in most cases
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for people? Obviously knowing it's
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probably the individual's call as to
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what you know their scenario is, but do
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we see people trending to one of those
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more so than the other? Yeah, at the end
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of the day, it it really is an
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individual level decision about how
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sensitive you are to the price today and
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whether those interest costs are really
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the barrier to getting into the home
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versus your risk tolerance. Are you
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willing to to face the interest rate
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risk in those future years? Certainly,
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the shorter time period that you lock in
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the rate, so that five-year product,
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that is going to give you the biggest
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interest rate savings today, but it
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means you're going to be exposed to the
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market the soonest. And so as you're
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kind of planning around this, you know,
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I think the 10- one arm, the 10-year
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option where you lock in for 10 years
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and it floats thereafter, that's going
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to meet a lot of first-time buyers needs
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when they're thinking about, you know,
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how long am I going to be in this house?
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Am I likely to refinance in the next 10
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years? Am I likely to move in the next
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10 years? And so it's really thinking
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about those kind of trade-offs, but it
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really is trading a, you know, certain
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savings right now for a very uncertain
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cost in the future. But with the
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dynamics of what we're seeing right now
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in the marketplace, I guess the
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assumption has to be that this type of
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activity is going to be potentially more
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prevalent at least in the short term.
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>> Yeah. Well, I think we're coming to a a
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maybe a distasteful realization that
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these higher interest rates are going to
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be here for a much longer time. And even
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where the interest rates are today,
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which are in the low sixes, you know,
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that's still below the sort of the
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long-term average of where mortgage
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rates have been. Um, so I'm sure some of
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the listeners will be familiar with
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where interest rates were in the early
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1980s. Um, but even over a long time
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period, it's very common to see mortgage
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rates in the sevens. And so, you know, I
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think this is just a a a very slow
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realization that mortgage rates are not
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going to be back in the fours anytime
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soon and we need to adjust to that
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reality and and one way to do that is by
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looking at alternative products.
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>> My parents gave, you know, still cringe
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at some of the rates that they saw back
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in those days as well. So, I totally get
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it. Hey, Ben. Mine too.
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>> Yeah, Ben, thanks very much for your
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time today. All the best.
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>> Absolutely. Thanks for having me, Dan.
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>> You got it. Ben Keys, who's a real
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estate professor here at the Wharton
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School.
