Housing Finance Debate: A Return to ARMs?

July 17, 2009 — -- They were one of the scourges of the housing crisis, but are adjustable-rate mortgages on the verge of a comeback?

It depends on whom you ask.

Last week homebuilder Toll Brothers announced that, in certain housing markets, it would offer its homebuyers ARMs featuring a 3.75 percent interest rate for the first seven years of the loan and a reset rate capped at 8.75 percent for loans at or below $417,000. To qualify, home buyers must have credit scores of at least 720.

Don Salmon, the chief executive of TBI Mortgage Company, Toll Brothers' mortgage division, told ABCNews.com that on the weekend following the announcement, the homebuilder saw a spike in interest that's unusual for the typically slow summer season. Other homebuilders and lenders, he said, might follow Toll Brothers' lead.

"If the product makes sense to the consumers, then consumers will demand it (and) then the lender will offer it," he said.

But others, like Bankrate.com senior financial analyst Greg McBride, are skeptical.

"People have been scared away from adjustable-rate mortgages and at the same time, the factors that led them to pick adjustable rate mortgages in the first place have dissipated," McBride said.

As of July 10, roughly 5 percent of borrowers chose ARMs, according to the latest data from the Mortgage Bankers Association. That represents an uptick from earlier this year but it's still far from the highs last seen in the summer of 2007: At that time, more than one in five borrowers chose adjustable-rate loans.

Toll Brothers' rate notwithstanding, McBride said the average interest rate for 7-year ARMs is 5.55 percent -- just 0.2 percentage points lower than the average rate for a 30-year fixed loan.

"The value for the overwhelming majority of homeowners is in fixed-rate mortgages," he said.

Adjustable-rate mortgages, McBride said, were a niche product that became popular during the housing boom as buyers used them as an "affordability crutch" -- in other words, buyers who might not have been able to afford the rates on a traditional, 30-year-fixed mortgage could qualify for with the lower initial rates on adjustable loans.

While the housing market was strong, many homeowners with ARMs figured they could sell their homes before their interest rates reset or refinance into fixed-rate home loans.

Those assumptions often proved false and defaults by adjustable-rate mortgage homeowners -- particularly for homeowners with bad credit who took out subprime adjustable-rate loans -- played a key role in driving foreclosures to record highs.

An 'Iron Stomach' for ARMs

McBride said that a homebuyer today would be foolish to assume they could find a bank to refinance them out of an ARM. And taking the bet that you'd be able to sell your home before the reset requires a "cast iron stomach," he said.

Banks and investors who buys home loans from lenders aren't keen on ARMs either, McBride said.

"The secondary market been dead for a couple of years," he said.

Salmon says that Toll Brothers, however, won't have trouble selling its ARMs. The delinquency rate for Toll Brothers borrowers, he said, is less than 1.7 percent. The homebuilders' underwriting standards -- including the 720 credit score minimum -- are prudent, Salmon said.

"We have a very strong buyer profile and our delinquencies historically are lower than the market, therefore our product is more attractive to banks," he said.

There may be more than just buyer stats working in Toll Brothers' favor.

McBride said that since Toll Brothers is a homebuilder and a lender, they have a flexibility that traditional lenders don't -- the costs of offering ARMs could be offset by the increases in home sales.

Still, David Ledford, the senior vice president for housing finance and land development at the National Association of Homebuilders, said that as of now, most other homebuilders haven't followed suit.

Instead, to combat the continued lack of demand from would-be homebuyers, other builders are subsidizing fixed-rate mortgages to offer lower rates, he said.

Some homebuilders have gone a few steps further, offering pre-paid homeowner association dues, free parking, free flat-screen televisions or new furniture.

Such incentives have become more common among homebuilders because, unlike many individual home sellers, the builders stand to lose more money the longer their homes go unsold, Scott Nagel, the vice president of real estate operations for the online realty company Redfin, recently told ABCNews.com.

"Most of the time, they've got their costs sunk," he said. "They're making payments on the construction loans that they used to build those condos and those homes. Every month they're not selling, it's another month it's eating into their profit margin."

Toll Brothers, which finds that many of its buyers are existing homeowners, offers some help in selling their old homes. In some communities, they assist in making old homes look more attractive to buyers by eliminating clutter, paint touch-ups and other small fixes. Toll Brothers also offers guidance on marketing your old home.

"We do many things to help people sell their homes," Salmon said, "because we know that that eases the path to settling in our home."