With the unexpected increase in property prices and the sudden spike in interest rates, the adjustable rate mortgage is somehow making a comeback.
Demand for Adjustable Rate Mortgages Expected to Rise in 2022
As mortgage rates keep going higher and higher, the demand for new mortgages fell 8.3% in mid-April 2022. It makes the demand only half of what it was last year.
You can’t blame consumers for the lack of interest in mortgage applications. The continually rising rates are the main culprits here. To date, the average contract interest rate for 30-year fixed-rate mortgages is 5.37%, compared to 3.17% about a year ago. The said rate (for loans with a 20% downpayment) is the highest to date since 2009.
The upward movement of interest rates is clearly discouraging buyers and making it harder for them to own a property. The rise comes amid the ongoing demand for affordable housing. According to MBA economist Joel Kan, the recent decline in purchase applications now is a foreshadowing of potential weakness in home sales in the following months. It comes as, given that compared to a year ago, new mortgage applications fell to 8% from 17%. The number of applications is quite low, considering that springtime is supposed to be one of the best seasons to look for homes and investment properties.
The way things are going with real estate and mortgages is making consumers turn to adjustable mortgage rates or ARMs. The ARMs are offering lower interest rates, which makes them a more attractive and increasingly popular option now.
Related: Mortgage Rates: The Real Estate Investor’s Complete Guide
What Is an Adjustable Rate Mortgage?
An adjustable rate mortgage or ARM is a type of mortgage that comes with an interest rate that changes – or adjusts – at different times within the duration of the loan. Depending on the prevailing market conditions, the rates can either go up or down.
ARMs are once again in the public eye because, compared to fixed-rate mortgages, they offer very low introductory rates. It means that borrowers enjoy the benefit of affordable monthly payments initially.
Lenders offer different types of adjustable rate mortgage loans but the most popular is the 5/1 ARM, in which the introductory rate lasts for five years before the interest rate changes annually.
Consumers also receive added protection against steep monthly interest rate changes because ARMs come with the following caps that limit the amount by which payments and rates change:
- Periodic Rate Cap: This limits the annual interest rate change.
- Lifetime Rate Cap: This limits how much the interest rate can go up over the life of the loan.
- Payment Cap: This limits how much the monthly payments can go within the entirety of the loan’s duration. It is measured in dollars and not in percentage points.
Related: 5/1 ARM Loan: What Investors Should Know
The Pros and Cons of ARMs
For those who are thinking of going with adjustable rate mortgages at this time, you need to consider their benefits and drawbacks.
Pros
- It comes with lower introductory interest rates, translating to lower monthly payments where more money can be allocated toward the principal amount.
- Depending on how the economy is performing, there is a chance that interest rates and the monthly payment will go down.
- There are cap limits that protect borrowers from steep prices and interest rate increases.
Cons
- Even with the cap limit in place, interest rates may rise beyond what’s affordable depending on the individual’s financial situation and capacity.
- A prepayment penalty is quite possible.
- Its more complex structure may be harder to understand for some individuals.
ARMs vs Fixed-Rate Mortgages
Unlike ARMs, fixed-rate mortgages carry the same interest rate for the entire duration of the loan. It can last for 10, 20, 30, or more years, depending on the type of loan acquired. They typically come with higher interest rates, which make ARMs attractive to borrowers and consumers at least for a few years.
The main advantage that fixed-rate mortgages can give borrowers is they are assured that the interest rates won’t shoot past a certain number, something that ARMs cannot guarantee. The interest rate adjustments for adjustable rate mortgages will depend on the economy at the time of the adjustment. If the economy is doing well, interest rates (and monthly payments) will go down. However, if the economy is shaky and unstable, both interest rates and monthly payments will inevitably go up.
Related: Adjustable-Rate Mortgage vs Fixed-Rate Mortgage: Which Is Better for a Real Estate Investor?
What Is Non-QM Lending?
Another type of loan that is creeping up in demand is a non-QM loan. Non-QM loans, or non-qualified mortgage loans, are mortgage loans that qualify borrowers based on alternative verification methods. Typically, lenders perform income verification for loan applicants to see whether they have the capability to make regular payments. Non-QM loans aren’t required to meet the federal government’s guidelines for qualified mortgages.
Some examples of non-QM loans include, but are not limited to, the following:
- Bank Statement Loans: Bank statements are the only ones needed to qualify for this type of non-QM loan. Some folks are even able to get loans using as little as two months’ worth of bank statements. It is especially helpful for self-employed individuals, entrepreneurs, consultants, and business owners.
- No Income Investment Loans: This type of loan can be beneficial for real estate investors as it allows them to build their portfolios with fewer setbacks. A debt-service-coverage-ratio loan doesn’t take into account an investor’s personal income but uses their rental property income to qualify.
- Asset-Based Loans: These loans allow borrowers to leverage assets they already have to secure a new loan. They may include savings and checking accounts, money market accounts, investment accounts, and other similar asset types. While such types of loans are quite ideal for investors with substantial liquid assets, the downside is they entail higher interest rates.
- Interest-Only Home Loans: Certain non-QM lenders offer this type of loan where you only need to pay the interest on specific loan types like a 30-year fixed loan or a 5/1 ARM. On the upside, it can help an investor build a substantial amount of savings. Keep in mind that you are not going to make any payments toward the principal balance for the duration of the interest-only period.
- Commercial Rental Property Loans: Investors who are looking to expand their portfolio with single-family units, multi-family homes, condos, or townhouse complex might want to consider this type of loan.
Investors can take out commercial rental property loans to purchase condominiums or apartments and expand their real estate portfolio.
Why Should Investors Be Concerned About This?
A lot of industry experts and professionals agree that property prices and interest rates will continue their upward trend this year. However, the speed at which they are going was a bit unexpected. Several factors have contributed to the sudden spike in property prices and interest rates. One thing is for certain, though, they will continue to go up in the next few months.
Investors have become quite concerned about the development. It is now more challenging to find the best real estate deals that can give them a good return on investment.
That being said, ARMs are one of the best ways investors can afford to buy investment properties to flip. But it may not be good to use in purchasing rental properties for their traditional or vacation rental business.
ARMs give investors the benefit of lower initial interest rates for the first term of the loan. They can sell their properties within a short period of time to mitigate the risks of interest rate adjustments after the initial period. But if investors are planning on starting an Airbnb business or even a traditional rental, it might not be the best option.
Wrapping It Up
A real estate investor may use an adjustable rate mortgage to acquire real estate properties even amid challenging times. That is as long as they have a good exit strategy in place.
When it comes to finding the best deals to use an ARM on, investors can always turn to a real estate website like Mashvisor. The site allows them to find the right properties that align with their investment goals and criteria. It also gives them access to valuable real estate market data for proper analysis.
To start using Mashvisor’s real estate investment tools, sign up for a 7-day free trial today, followed by 15% off for life.