Adjustable-Rate Mortgages Are Making A Comeback In Southern California - Is There Reason To Worry?

They were all the rage during the growth of the housing bubble, and quickly became infamous when the market began to fall. Now, after spending a few years in relative obscurity, adjustable-rate mortgages are beginning to make a comeback. According to a recent report released by DataQuick, ARMs made up 10.9% of southern California home loans in the month of July. In June, the figure was 9.6%, and in July 2012, they made up only 6.2% of the mortgage market.

This trend shows that homebuyers are becoming slightly more risky with their property investments. Just earlier this year in February, cash purchases made up 36.9% of all real estate sales. In July, that number has decreased to 29.4%. Why are homebuyers turning to adjustable-rate mortgages, and is there a need to worry about the San Diego real estate market in the near future?

Why Some Homebuyers Are Choosing ARMs

With adjustable-rate mortgages nearly doubling their presence in their home-finance world over the last year, it is evident that many buyers are finding “good” reasons to choose these types of loans. For most new homeowners choosing ARMs, there are likely two causes for doing so:

  • >Interest Rate Increases Have Lowered Purchasing Power –Over the past few months, interest rates have seen an increase. For potential homebuyers who have been waiting for their perfect home to come onto the market, this rate increase means less purchasing power. If a family had budgeted $2,500 each month for their new mortgage, that equates to less home now that rates are slightly higher. In order to purchase the home that they want (without adjusting their expectations or starting off with a higher monthly payment), the family is forced to consider an adjustable-rate mortgage with a low introductory offer.
  • Betting On An Increase In Value – Since housing prices in San Diego have risen significantly over the past year, many homebuyers expect that trend to continue. In their mind, interest rates may rise, but by the time any significant rate increase kicks in, these buyers plan to refinance or sell, and cash out all of the extra equity they've gained. This was a huge part of the reason why ARMs are so hated – as we've seen in the past, huge payment increases or San Diego property values which do not rise as quickly as expected can cause major trouble for anyone with an adjustable-rate.

Didn't ARMs Cause A Lot Of The Trouble Last Time Around?

Just like almost all financial products, adjustable-rate mortgages fit into the market in their own way. In an economy where interest rates are decreasing, ARMs provide protection against interest rate risk. This means that with an adjustable-rate, you don't have to worry about being locked into paying a higher interest rate than what is currently offered, as you would with a fixed-rate loan.

On the other side, when interest rates are rising like we've seen in the past few months, adjustable-rate mortgages protect your lender from mortgage rate risk – in this circumstance the chance that their money will be loaned out at a rate lower than what cash is being lent out for in the marketplace. For homebuyers, this means an increase in their monthly payments. With rates currently so low, even a small increase can turn into a proportionately significant additional monthly payment.

This is what happened last decade, as interest rates rose and as “introductory” low rates expired, and it turned into a mess for the financial sector.

For the past two years, interest rates had stayed quite steadily around 3.5%. There has been much volatility this year, and since May, rates have increased by over a full percentage point. Now, rates are hovering at 4.5%, but that number seems to change each week.

With an overall upward trend showing in the mortgage market, an ARM is likely to be a poor decision in nearly all cases. Apart from the recent rate increases we've seen, there is one more principle that has been touched on which should deter homebuyers from these types of loans – they are generally only advantageous when interest rates are falling. Even with the gain we've seen lately, there is not too much room for rates to decrease, but a significant amount of room for them to still grow. In fact, for the twenty years prior to the housing collapse, average interest rates ranged from 6% (at the height of the housing bubble), to over 10.5%.

What Do These Adjustable-Rate Mortgages Mean For The San Diego Real Estate Market?

In the grand scheme of things, this small increase in adjustable-rate mortgages will likely have very little effect on San Diego home values. While they have nearly doubled in popularity over the previous twelve months, their share of the entire local mortgage market is very low. Over the past thirteen years, since 2000, ARMs have accounted for approximately 32% of all home loans in southern California. Even by “average” figures, the current 10.9% looks small. Compared to the extremely disproportionate numbers seen during the housing bubble, the present percentage of adjustable-rate loans appears almost insignificant.

If you're purchasing a home, however, choosing your mortgage is not an insignificant choice. On a personal level, the hazards of an adjustable-rate mortgage can be quite real and have serious consequences for your finances. Always explore all of your options, and perhaps take a look at your home choice before agreeing to a mortgage which could rise in cost in the future. Although ARMs pose little threat to the San Diego real estate market right now, educating consumers to their dangers can prevent that number from growing to hazardous levels again in the future.