Adjustable rate mortgage (ARM) rates have increased going into 2017 with the average rate for a 5/1 ARM climbing to 3.32 percent in January up from 3.28 percent the previous year. This is due in part to the Federal Reserve’s move to raise the target federal funds rate and these rates are projected to increase.
The federal funds rate has a significant bearing on the US economy. It is the interest rate with which depository institutions lend each other funds kept at the Federal Reserve.
ARM rates are expected to rise continually in relation to the federal funds rate for the rest of the year. This is good for the housing market’s stability since high ARM rates can inhibit ARM over-use.
However, this can be negated by higher fixed rate mortgage (FRM) rates which are projected to climb once again later this year. ARMs surge in popularity when FRM rates soar although regulators are expected to restrict ARM use in order to prevent a foreclosure crisis.
A short history of ARM rates
ARM rates fluctuate in accordance with the market unlike FRM rates, which stay the same throughout the mortgage’s lifespan.
Indexes used for periodic ARM rate adjustments include:
- 12-month Treasury bill which is the the most common index for ARMs
- Six-month Treasury bill
- Three-month Treasury bill
- Average yield of treasury securities at one-year constant maturity
- Cost of funds
- Intercontinental Exchange London Interbank Offered Rate(LIBOR/ICE LIBOR) or the benchmark rate at which leading banks charge other banks for short-term loans
The federal funds rate is among the interest rates with the biggest influence on ARM rates as it affects most indices that ARMs are tied to.
The Federal Reserve’s target rate was set at 0 to 0.25 percent from 2009 up to December 2015. The Fed then raised it to 0.25 percent to 0.5 percent to gear up for the economy’s expansion.
The average ARM rate climbed by 0.3 percentage points between December 2015 and January 2016 which is the highest increase seen in a single month since 2013. It dropped for most of 2016 before climbing again towards the end of that same year.
The danger of ARM over-use
ARMs generally pose more risk than FRMs. Adjustments result in higher payments and payment shock making numerous homeowners unable to cope.
The average ARM rate peaked at around 6 percent in 2006 and three out of every four mortgages in California at the time had been ARMs. Although many homeowners intended to refinance into FRMs before their ARM reset, the high unemployment rate during the economic downturn made refinancing impossible.
This partly contributed to the foreclosure crisis that took place in 2008 and 2009. Buyers began avoiding ARMs in the aftermath of the crisis. Underwriting standards also became more stringent with more emphasis on the reset rate and not the teaser rate which is the initial interest rate before adjustments take place.
ARM rates in the near future
ARM rates are projected to rise over the coming years since the federal funds rate hit bottom in 2015 and can only go up from there. Moreover; the average ARM rate follows a 60-year rate cycle which also hit bottom in 2012.
ARM use will stay minimal going into 2017 is FRM interest rates remain low. However, investors might regain confidence as the US economy improves and allow FRM rates to rise. If this happens, ARM use will likely increase.
However; there’s a low possibility of ARM over-use as the foreclosure crisis is still fresh in the minds of regulators and buyers.
