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