ARMs Today are Different than the Pre-Crash ARMs

During the past decade, homebuyers have mostly preferred fixed-rate mortgages (FRMs) over adjustable-rate mortgages (ARMs). Proof of this is the precipitous drop in the ARM share of the dollar volume of originations from almost 45 percent during mid-2005 to a low of 2 percent in mid-2009 (Figure 1). Since then, the ARM share has fluctuated between about 5 and 13 percent, generally rising when FRM rates increase and falling when FRM rates decline. As of Q1 2017, the ARM share accounted for 8 percent of all conventional residential mortgage originations, up 2 percentage points from Q4 2016. If FRM rates increase in the coming year, the ARM share will likely increase.

ARMs are more common among homebuyers borrowing large-balance mortgage loans than for those with smaller loans. Among mortgages of more than $1 million originated during Q1 2017, ARMs comprised 47 percent, up 4 percentage points from Q4 2016 (Figure 2). Among mortgages in the $400,001-$1 million range, the ARM share was about 13 percent, up 3 percentage points from Q4 2016. However, among mortgages in the $200,001-$400,000 range, the ARM share was just 4 percent for Q1 2017, up 2 percentage points from the previous quarter.

Historically, borrowers have favored ARMs when they were income-constrained or because they preferred the lower interest rate relative to FRMs, especially when the spread between a FRM rate and an ARM initial interest rate is wide. Unfortunately, ARMs received a bad reputation since those originated during the pre-crash period were more likely to default than FRMs. Underwriting standards were relaxed during the boom period as numerous risky products were available. These included the option ARM, which allowed the borrower to choose between several monthly payment options (including a negative amortization option) and the interest-only ARM, which allowed the borrower to pay only the interest, with no principal, during an initial period. Many automated loan approvals did not require full documentation, and some lenders didn’t always verify the borrower’s ability to repay.

The ARMs today are very different than the pre-crash ARMs. About 60 percent of ARMs originated during 2007 were low- and no-doc compared with only 40 percent for FRMs. Similarly, 29 percent of borrowers with ARMs during 2005 had a credit score below 640 compared with only 13 percent for FRMs. Today, almost all conventional loans, including both ARMs and FRMs, are full doc, amortizing, and made to borrowers with credit scores above 640.

Figure 3 shows the trend of four major variables of underwriting: credit score, loan-to-value ratio (LTV), debt-to-income ratio (DTI) and share of low- and no-doc. Based on these four variables, conventional ARMs today are better in terms of credit risk quality than are conventional FRMs, signaling a shift from the historical trend of FRMs having higher quality. As of Q1 2017, the average credit score of borrowers with ARMs was 765 compared with 753 for borrowers with FRMs. Similarly, the average LTV for borrowers with ARMs was 67 percent compared with 74 percent for borrowers with FRMs. The average DTI for borrowers with ARMs is also slightly lower compared with the DTI for borrowers with FRMs. Overall, these charts illustrate that ARMs today have much lower credit risk than ARMs of a decade earlier, and in addition, have lower risk attributes than today’s FRMs.

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