Adjustable-rate mortgages may never make a comeback

Adjustable rate mortgages, or ARMs, have gotten a bad rap from homebuyers, who have long viewed them as a dangerous financial trap. With fixed-rate mortgage rates more than doubling over the past year, some borrowers are taking a second look. The idea of ​​paying less now in exchange for the risk of paying more later seems reasonable when you think interest rates are nearing their peak.

By sticking with a traditional 30-year fixed-rate mortgage, homebuyers could be paying more than they need to in a market where rates are more likely to fall than rise over the next few years — or at least stabilize.

But don’t bet many homeowners take that risk. In the US, ARMs have taken a back seat to 30-year fixed-rate mortgages for decades. And if you look at Americans’ experiences with long-term financing, you can see why that’s unlikely to change now.

In the 1800s, anyone who wanted to borrow money to buy farmland or a home typically entered into a contract known as a balloon loan with lenders, which included banks and wealthy individuals. These loans only lasted for three or five years because government regulations did not allow for long-term real estate loans. At the end of the term, the borrowers had to pay off the entire principal amount. Payments, once modest and manageable, would suddenly explode – hence the name.

In reality, however, few people have paid back the loan in full. Instead, they would return to the lender to negotiate and refinance with another balloon mortgage. They can do this multiple times before paying off the principal amount in full.

This was a very crude version of an adjustable rate mortgage: market forces set the interest rate each time the borrower took out a new loan. And therein lay a serious problem. If the mortgage was renewed during a period of high interest rates, the homeowner who couldn’t afford to refinance would have to pay the entire balance immediately or face foreclosure.

This is exactly what happened after balloon mortgages peaked in the real estate boom of the 1920s. When the Great Depression hit, the real estate market collapsed, taking the financial system with it.

In response, the federal government began intervening in the housing market on an unprecedented scale. In 1933, the newly formed Home Owners’ Loan Corporation began making low-interest, fixed-rate, long-term loans with more modest down payments. The Federal Housing Authority, formed the following year, insured mortgages, while Fannie Mae (the Federal National Mortgage Association) helped create a secondary market in 1938.

In the aftermath of World War II, a complex jungle of government programs and agencies cemented the 20-year fixed-rate mortgage as the norm. By the 1950s, 30-year loans had become standard. Homeownership rates rose.

But rising inflation and rising interest rates in the late 1960s and early 1970s put an end to this heyday. The savings and credit unions on the frontline of mortgage lending were tied to long-term, fixed-rate loans. As inflation continued to rise, their borrowings could not keep up with the higher interest rates they had to offer to attract short-term deposits.

As prices continued to rise in the early 1970s, some S&Ls in California and Florida (which were not subject to federal regulations) experimented with adjustable rate mortgages. Interest rates were lower than fixed rate loans, but they rose or fell with the market, reducing risk for lenders.

These forays inspired policymakers at the Federal Home Loan Bank Board to conclude that adjustable mortgage rates were the wave of the future. They asked Congress to approve the idea but were quickly denied even after the board offered to limit rate hikes to 2.5% regardless of inflation.

The refusal was mainly due to the anger of trade unions and consumer organizations. Elizabeth Langer, executive director of the Consumer Federation of America, stated that “an interest rate hike would put a terrible burden on Americans.” George Meaney, chief of the AFL-CIO, threatened that “homeowners would have to demand higher wages and salaries to keep up”.

But as inflation continued, the board of the Federal Home Loan Bank relented and allowed adjustable-rate mortgages until 1981. A consumer union spokesman condemned the move as an “abomination” and predicted that buying a home would become “Russian roulette”.

The hatred of ARMs wasn’t irrational. Many consumer groups feared that potential homebuyers would fixate on the lower “teaser” starting rates and fail to assess the risk of a rate hike.

Nonetheless, ARMs accounted for 68% of new mortgages in 1984, suggesting they were here to stay. Instead, their popularity proved fleeting when events reversed in favor of the 30-year fixed-rate mortgage.

First came the complaints about adjustable rate mortgages. As they grew in popularity, mortgage lenders began selling the loans in ways that confused and increasingly angered borrowers. Newspaper articles quoting confused borrowers who were shocked that their interest rates had risen — or, in some cases, that they hadn’t come down even as interest rates fell — became a staple of personal financial reporting.

Even the financial sector acknowledged there was a problem. As early as 1984, the CEO of First Nationwide Financial Corp. quoted in the Washington Post as warning that teaser prices are a “bait-and-switch” tactic that would backfire. The same article quoted a mortgage banker who had openly admitted to being a misleading borrower: “We’d like to be straightforward,” he noted, “but we wouldn’t get credit that way.”

Other developments conspired to prevent the adoption of ARMs. By the early 1990s, interest rates had stabilized at lower levels, increasing the profitability of fixed-rate financing. The growing complexity of ARMS also deterred borrowers: one study counted more than 300 different types of ARMs on offer. Faced with a classic version of the “paradox of choice,” many Americans chose the safer and more familiar fixed-rate mortgage.

Equally important has been the rise of securitization, which spares undercapitalized lenders the risk of managing assets over a 30-year period. Although the bundling of mortgages into securities has a long history, it became more common for banks to divest fixed-rate mortgages from the 1990s onwards. In contrast, ARMs were more difficult to securitise, although this was less important due to the lower risks they posed to lenders.

On the eve of the 2008 financial crisis, ARMs enjoyed a brief renaissance, but it was largely confined to the subprime market, with borrowers not having the credit to draw down traditional fixed-rate mortgages. Inevitably, the borrowers who flocked to ARMs were the most likely to default, and their failure to pay their mortgages helped trigger a global financial crisis. Once again, ARMs got a bad rap.

Perhaps the current painful wave of inflation, after such a long period of low interest rates and cheap mortgages, will inspire more homebuyers to consider ARMs. But history suggests that Americans’ preference for 30-year fixed-rate mortgages, which arose in the depths of the Great Depression, will not change.

Perhaps for good reason — homeownership rates are much lower in other countries, largely because they rely more on ARMs. Even with higher interest rates, the security of a fixed-rate mortgage can be worth the extra price in economically uncertain times.

More from other authors at Bloomberg Opinion:

Adjustable mortgage frenzy isn’t the same as 2008’s Alexis Leondis

What if the rental market crashes first?: Conor Sen

Biden lets homeowners down in inflation fight: Karl W. Smith

This column does not necessarily represent the opinion of the editors or of Bloomberg LP and its owners.

Stephen Mihm, history professor at the University of Georgia, is co-author of Crisis Economics: A Crash Course in the Future of Finance.

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