Which Households Prefer ARMs Vs. Fixed-Rate Mortgages?

In this blog post, we look at the different characteristics of households holding adjustable-rate mortgages (ARMs) and fixed-rate mortgages in the 2019 Survey of Consumer Finances (SCF). Despite the current release of the 2022 SCF, we have chosen to utilize the 2019 SCF because it does not consist of any of the modifications and dynamics connected with the COVID-19 pandemic, which are beyond the scope of this article. Motivated by the present high mortgage rates, which can make exceptional ARMs more costly when their rates reset, we are interested in discovering which debtors are exposed to these higher rates. We discovered that households holding ARMs were more youthful and made greater earnings which their preliminary mortgage sizes were bigger and had larger exceptional balances compared with those holding fixed-rate mortgages.

Characteristics of ARMs

About 40% of U.S. homes have mortgages, of which 92% have actually fixed rates and the remaining 8% have adjustable rates. Fixed-rate mortgages have a set rates of interest for the life of the loan, which must be paid on top of the principal loan amount. Adjustable-rate mortgages have rates that normally track a benchmark rate that reflects existing financial conditions and is more carefully impacted by the rates of interest set by the Federal Reserve.Although rates for ARMs are created to be adjustable, rates on ARMs are often fixed for an initial period, generally 5 or 7 years, after which the rate is generally reset annually or two times a year. Additionally, ARMs may have restrictions on how much the rates can change and a total cap on the rate.

For example, throughout the Fed's existing tightening period, the 30-year mortgage rate increased from 4.8% in October 2018 to 7.6% in October 2023, while the rate on the 5/1 ARMThis indicates the rate is complimentary to adjust every year after being fixed for the very first 5 years. increased from 4.1% to 7.6% throughout the very same period. To put this in perspective, think about a home that borrowed $200,000 utilizing a 5/1 ARM in October 2018. This family made month-to-month payments of $964 during the very first five years of the mortgage. The month-to-month payments then increased to $1,412 in October 2023, when the rate adjusted.
bloglines.com
By contrast, a fixed-rate would not experience a boost in payments in 2023, having locked in the lower rate for the life of the loan. Given this threat, fixed-rate mortgages generally have greater introductory rates. Had the family taken out the very same $200,000 in a fixed-rate mortgage at 4.8%, the payment would have been $1,053 in October 2018, however then it would have stayed continuous in 2023.

Mortgage payments represent about 30% of home income, and as we displayed in an earlier Economic Synopses essay, impressive mortgages represent about 70% of household liabilities, so this boost in month-to-month payments represents a significant additional problem on homes.

Identifying Households with ARMs

To understand which homes are most impacted by modifications in rates of interest through ARMs, we calculated the share of homes with mortgages that hold either ARMs or fixed-rate mortgages across the income circulation and compared some general characteristics of these households and their mortgages, consisting of the rates, the preliminary size of the mortgages, and the remaining balance.
bloglines.com
The figure below programs the share of mortgages by earnings decile. Overall, ARMs represent a minority of total mortgages.

Distribution of Kinds Of Mortgages by Income Decile

SOURCES: 2019 Survey of Consumer Finance and authors' calculations.

NOTE: Households are divided into income deciles, in which the first decile represents those with the least expensive income and the 10th represents those with the highest earnings.

As revealed in the figure, the share of mortgages that have adjustable rates is usually greater amongst families in the higher-income deciles: 18.8% in the leading decile (the 10th) compared with 6.5% in the bottom decile (the first). While our numbers are based on the 2019 SCF, this Wall Street Journal short article reported that ARM applications were just over 7% of all mortgage applications in 2023

One possible description for why holding ARMs is more concentrated in higher-income deciles is that families with higher income are more able to absorb the danger of higher payments when interest rates increase. In exchange, these families can benefit immediately from the lower introductory rates that ARMs tend to have. On the other hand, households with lower earnings may not be able to afford their mortgage if rates get used to a significantly higher level and therefore choose the predictability of fixed-rate mortgages, particularly since they have the option to refinance at a lower rate if rates drop.

The table listed below reveals some other basic attributes of ARMs and their borrowers versus those of fixed-rate mortgages and their debtors.

ARMs tend to have lower interest rates. However, the average preliminary borrowing quantity is over $40,000 bigger for ARMs, and the mean staying balance that homes still need to pay is likewise bigger. The average household earnings among ARM holders is also 50% more than the mean income of those holding fixed-rate mortgages. This follows the figure above, in which the share of ARMs increases among higher-income families. The mean age of ARM holders is likewise 18 years lower.

ARMs Appear to Skew towards Younger, Higher-Income Households

In sum, ARMs seem to be more popular with younger, greater income families with larger mortgages, and ARM ownership relative to fixed-rate ownership nearly tripled from the bottom to top income decile. Given their age and income, these types of families might be better equipped to weather the danger of changing rates while their proportionally bigger mortgages gain from the lower initial rates.

Notes

1. Despite the current release of the 2022 SCF, we have picked to use the 2019 SCF because it does not consist of any of the changes and characteristics associated with the COVID-19 pandemic, which are beyond the scope of this post. 2. Although rates for ARMs are designed to be adjustable, rates on ARMs are frequently fixed for an introductory period, usually 5 or seven years, after which the rate is normally reset annually or twice a year. Additionally, ARMs may have restrictions on how much the rates can change and a general cap on the rate.