Mortgaged homebuyers running up against rising interest rates are now facing another obstacle: tightened access to mortgage credit. The result has been a drastic cut to mortgage application numbers in recent weeks.
Purchase mortgage application volume decreased in the week ending June 3, 2022, down 18% from the prior week. This was also down 21% from a year earlier, according to the Mortgage Bankers Association (MBA).
These factors have produced the lowest level of mortgage loan application volume in 22 years — foreboding news for future home sales volume.
Further, even as fewer homebuyers and refinancers are applying for mortgages, lenders are granting fewer approvals. Called mortgage availability, this index declined for the third month in a row in May 2022 to 30% below pre-pandemic lending standards, according to the MBA. Wary of the financial fallout from rising interest rates and the impending recession, lenders are tightening their purse strings in advance of the coming storm.
The average 30-year fixed rate mortgage (FRM) rate is 5.23% in the week ending June 10, 2022. FRM rates increased rapidly in the first months of 2022, from a low near 3.00% in January 2022 to today’s high rate. The result has been a dramatic cut to buyer purchasing power, with the typical mortgaged homebuyer now limited by 25% less mortgage principal available due to interest rate hikes alone.
Related article:
Buyer purchasing power has plummeted 25% with interest rate hike
With their options for mortgage money narrowing, desperate homebuyers are turning to a dangerous solution: adjustable rate mortgages (ARMs).
The dangers of ARM over-use
As interest rates have rapidly increased, homebuyers in search of relief are embracing the seductively low teaser rates on today’s ARMs. The ARM share of mortgage applications is 8.2% as of the first week of June 2022, up significantly from 3.7% a year earlier.
From a homebuyer’s perspective, today’s increased reliance on ARMs is understandable. After all, California home prices continue to rise, now 20% higher than a year earlier in the low tier and a whopping 28% higher in the high tier. As long as income increases are falling below the rapid pace of home prices, homebuyers’ only option to keep up is to find lower mortgage rates — now a thing of the past.
ARMs provide a quick fix to homebuyers in search of more money. However, the risks are clear.
The ARM rate homebuyers use to compare against FRM rates are just where the rate starts, called the introductory or teaser rate. During this introductory period — which can be anywhere from ten months to ten years, depending on the term the homebuyer chooses — the homebuyer pays the low teaser rate.
Thus, while the lower rate saves homebuyers money during the short term, once the teaser rate resets and adjusts, their payment will also shift. How much it will shift is unpredictable — hence, the danger.
The amount of rate adjustment is based on the index to which the ARM is tied, chosen by the lender upon origination. As the index figure rises or falls, so does the ARM interest rate. Some common indices lenders use to adjust their ARM rates include the:
- 11th District Cost of Funds Index (COFI);
- 12-month Treasury Average; and
- Secured Overnight Financing Rate (SOFR), which recently replaced the ethically dubious London Interbank Offered Rate (LIBOR).
To arrive at the new interest rate, the lender takes the index rate plus an agreed-to margin. For example, if the index rate is 3% and the margin is 2%, the note rate the homebuyer pays is 5%.
ARMs are riskier than FRMs because the rate reset often results in substantially higher payments — payment shock. This was experienced on a large scale following the Millennium Boom when three-out-of-four homebuyers used ARMs. Lenders and agents alike counseled their homebuyer clients to consider ARMs to keep up with the rapidly rising price environment of the mid-2000s. Their motto was: “You can always refinance before the rate adjusts!”
But when their ARMs reset and payments rose beyond homebuyers’ ability to pay, homebuyers who had lost jobs during the Great Recession were unable to refinance and unable to sell due to their negative equity status.
The result: California’s foreclosure crisis.
It’s unlikely today’s relatively low 8.2% ARM share will lead to another crisis of 2009-2012 proportions. However, the market is tipping towards instability.
Expect many of today’s homebuyers to end up in poor financial straits within the next year. As home sales volume continues to decline and higher interest rates persist, home prices will inevitably decline. When that happens, recent homebuyers will be plunged underwater. Then, it’s a ticking time bomb until the rate resets for today’s ARM users.
Real estate professionals: stay up-to-date with today’s rapidly shifting housing market and economic conditions at firsttuesday’s Recession Watch page. Prepare now for the fallout to survive the coming recession.
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