Surge in Adjustable-Rate Mortgage Applications Amid Rising Interest Rates and Tougher Lending Standards

Key Insights

• Homebuyers are increasingly turning to adjustable-rate mortgages (ARMs) as fixed mortgage rates hit multi-decade highs.
• With mortgage rates nearing 8% or higher, ARMs offer more manageable monthly payments, fueling their growing popularity.
• Following the subprime mortgage crisis, ARMs lost favor but have regained traction since May 2022, surpassing 9% of mortgage applications.
• Borrowers with ARMs could benefit from anticipated Federal Reserve rate cuts expected next year.

As mortgage rates climb, adjustable-rate mortgages (ARMs) are becoming a preferred choice for many prospective homebuyers. The Mortgage Bankers’ Association reports that ARM applications now account for 9.5% of all mortgage requests, the highest since November 2022.

ARMs feature an initial fixed interest rate period, followed by periodic adjustments—annually or monthly—allowing borrowers to start with lower rates before adjustments. This structure appeals to buyers facing historically high fixed mortgage rates, which have reached levels not seen in over two decades.

Historically, ARMs were linked to the 2008 financial crisis, as many homeowners struggled with rising payments after rate resets. Since then, lending standards have tightened significantly to mitigate risk. At their peak in April 2005, ARMs made up 35.8% of mortgage applications, but they dropped sharply after the crisis and only recently climbed back above 10% in May 2022.

CoreLogic data reveals that ARMs represented 16% of the total mortgage value in August 2023—quadruple the share from January 2021 when ARMs accounted for just 4%. Back then, the 30-year fixed mortgage rate was a low 2.74%, compared to today’s much higher rates.

Modern ARMs Differ from Early 2000s Versions

According to Selma Hepp, Chief Economist at CoreLogic, lenders now enforce stricter criteria for ARMs, including higher credit score requirements and income verification. Additionally, there is a preference for safer ARM products like 7/1 and 5/1 loans, which have longer initial fixed-rate periods.

Regulatory changes have also improved ARM safety. The Dodd-Frank Act requires lenders to provide advance notice before rate adjustments, and the LIBOR benchmark, once used for ARMs, has been phased out due to manipulation concerns.

Unlike the pre-2008 period, today's ARM borrowers are seeking relief from elevated interest rates driven largely by Federal Reserve policies. The Fed’s benchmark rate, which influences mortgage rates, currently sits at 5.5%, with indications it will remain steady for the near term. However, traders anticipate potential rate cuts next year, which could benefit ARM holders.

Looking Ahead

While forecasts predict Federal Reserve rate reductions in the coming year, uncertainty remains. Bill Hines, CEO of Emancipare Investment Advisors, notes that ARMs have become a popular topic among homebuyers but advises caution. He recommends ARMs primarily when rates are expected to decline, similar to the late 1970s when mortgage rates peaked near 18%.

Given the unpredictability of economic trends and Federal Reserve decisions, timing the market remains challenging. Hines advises clients to approach ARMs carefully, emphasizing the risks involved in attempting to predict interest rate movements.

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