Risky loan from housing-bust era is making a comeback

They are opting for adjustable-rate mortgages, or ARMs. These loans initially offer cheaper borrowing rates compared with a fixed-rate mortgage. But ARMs reset, usually after three to 10 years, which can saddle borrowers with higher monthly payments if mortgage rates have risen over that time.

That isn’t the only risk: Borrowers who want to refinance when rates drop might not qualify if they have had a job loss or another change in their financial situation.

But buyers are betting that mortgage rates will fall in the coming years, enabling them to refinance before the fixed terms of their ARM loans expire.

The average rate for a 30-year fixed mortgage in the five days ended Oct. 29 was 6.15%, compared with 5.46% for five-year and seven-year ARMs, according to mortgage-technology company Optimal Blue.

About 10% of purchase-mortgage applications were for ARMs in the week ended Oct. 3, the highest rate since 2023, according to the Mortgage Bankers Association. In early 2021, when mortgage rates were near historic lows, less than 3% of purchase applications were for ARMs.

Buyers are desperate for affordable monthly payments when home prices are up more than 50% since 2019 and are near all-time highs. Home-insurance and property-tax costs have also climbed in many parts of the country.

“We see more borrowers trying to get rates in the 5% range" to make their monthly payments more affordable, said Scott Bridges, a Pennymac executive who oversees consumer lending. “Typically with an ARM loan, that’s one of the only ways you’re going to get there."

Kyle and Audrey Everett bought a townhome in Washington, D.C., in May with a 5.25% seven-year ARM. They chose it over a fixed mortgage with a rate of 5.875%, which they could have afforded but would have cost them hundreds more a month.

“For us, it was a no-brainer to get to 5.25%," Kyle Everett said. “Hopefully rates will go down" so they can refinance to a fixed-rate mortgage below 5.875%, he added.

Mortgage rates generally tend to track government borrowing costs, but ARMs are more correlated with short-term rates while fixed-rate mortgages are more correlated with 10-year Treasury yields.

In 2023 and most of 2024, long-term Treasury yields were lower than short-term yields, making ARMs unattractive. The difference in rate between fixed mortgages and ARMs narrowed in 2024 to almost even, and in some cases ARMs had higher rates than fixed loans.

This year, ARMs again have lower upfront rates than fixed loans.

“In general in the borrower community, there’s more of a sense of calm about rates are more likely to go lower from here than they are to go higher," said Jeff DerGurahian, chief investment officer and head economist at LoanDepot.

The Federal Reserve cut short-term interest rates last week. Mortgage rates could keep declining if the Fed continues to lower rates, but the Fed’s decisions have been complicated by the government shutdown and lack of economic-data releases.

ARM usage was much higher in 2004 and 2005, when roughly a third of all mortgage applications had adjustable rates. Buyers welcomed ultralow initial rates, but then found they couldn’t afford the mortgage after the rate adjusted higher after only a couple of years. Millions of homeowners ended up in foreclosure after the housing market collapsed a few years later, partly because of ARM resets.

That isn’t likely to happen again. These loans are less risky today, thanks to tighter lending standards and caps for most ARMs on how much the interest rates can adjust.

ARMs are also getting a boost from home builders. Builders said on average that 14% of their buyers in the past month had used ARMs, according to an October survey by John Burns Research & Consulting. Large builders D.R. Horton and Century Communities noted an increase in ARM usage in recent earnings calls.

“People do want to come back into the housing market," said Rick Palacios Jr., director of research at JBREC. “It’s just they’re waiting for something that makes sense for them financially."

More than half of homeowners and renters surveyed by JBREC in September said they would consider an ARM if it offered a lower starting rate than a fixed-rate mortgage; only about one-third said they would feel uncomfortable doing so.

The ARM share of refinance applications has also climbed.

Many home buyers already plan to refinance or sell within five to 10 years, so they are less concerned by the prospect of a reset rate.

After more than a year of house hunting, Max Lynch and Morgan Mendoza bought a four-bedroom house in Grayslake, Ill., this summer for $750,000, which was at the top of their budget. They opted for a seven-year ARM, which is saving them hundreds of dollars a month compared with what they would have paid for a fixed-rate loan.

“It really just comes down to the expectation that the Fed will continue to cut rates over the next several years and the affordability that it offers in the immediate period," Lynch said.

Write to Nicole Friedman at nicole.friedman@wsj.com