The Risks Associated with Adjustable Rate Mortgages

Written by Paige Steinhauser

With mortgage rates on the rise, many Americans are forgoing fixed mortgages and instead turning to adjustable rate mortgages, or ARMs. ARMs have become increasingly attractive due to their low starting interest rates. However, ARM rates can alter after a certain period based on “changes in the corresponding financial index that is associated with the loan” (Bank of America, n.d.). Therefore, it is important for individuals interested in adjustable rate mortgages to understand the risks that are associated with them.

According to Joel Kahn, the vice president of Mortgage Bankers Association, purchase applications haven’t been lower since 1995, and refinance applications have fallen to the lowest level since January 2023 (as cited in Burns, 2023). As of December 13, 2023, the Federal Reserve announced that they will not raise interest rates in the coming months (Dehan, 2023). With a housing market near impossible to navigate, it is no surprise that there has been a recent uptick in the popularity of ARMs. In February 2023, certain adjustable rate mortgages boasted interest rates that were an entire point lower than the current 30-year fixed rate mortgage (Baker, 2023). ARM loans have climbed almost 10 percent and are continuing to increase, now accounting for almost 11 percent of all applications (Olick, 2023). However, it’s important to take into account that rates are ever-changing; more recent interest rate calculations of ARMs and fixed mortgages have illustrated that the gap between the rates is tightening.

Before deciding to purchase an ARM, it’s important to understand how the loan works. The most appealing feature of ARMs are their fixed-rate periods. The period of a fixed-rate can vary, typically spanning three, five, seven, or ten years. At this introductory point, the rates have the capacity to be lower than a traditional fixed rate mortgage; these smaller monthly payments give borrowers the opportunity for more home buying power (Lewis, 2023). Once the fixed period comes to an end, the borrower enters a period in which their mortgage can change, potentially rising. Key terms to comprehend in this variable period include the initial adjustment cap, subsequent adjustment cap, and the lifetime adjustment cap. The initial adjustment cap is defined as the maximum amount the interest rate of an ARM can change for the first time after the fixed rate period ends, while the subsequent adjustment cap illustrates how much an interest rate can change in following adjustment periods. The lifetime adjustment cap is the maximum interest rate you can receive over the entire span of the loan (Consumer Financial Investment Bureau, 2020). Similar to the fixed rate period, variable rates are subject to certain time spans depending on the specific loan the buyer purchases; most commonly, the variable rate will follow a sixth month or year pattern, meaning that rates can adjust every six months or year after the fixed rate period is over.

Now that the basics of an ARM have been explained, what are the risks associated with it? Can the positives outweigh the negatives? Historically, adjustable rate mortgages have proved to have an unpleasant impact on the housing market, specifically in the 2008 financial crisis. A wide variety of ARMs gained popularity in the 1990s and 2000s due to their permitting of borrowers with higher credit risks to gain access to capital. Jeffrey Loser, Assistant Attorney General for Ohio, largely attributes this to “predatory lending door-to-door [selling], even to consumers [who didn’t understand] what they were doing” (as cited in Zhao, n.d.). Option ARMs, a type of ARM in which borrowers can decide which type of payment is made to the lender, as well as other exotic loans, increased from 7 percent to 29 percent of the mortgage market from 2004 to 2006 (Zhao, n.d.). Data analysis illustrated that conventional ARMs had double the delinquency rate, or percentage of loans that are past due, than the conventional fixed rate mortgages at the height of the financial crisis (Zhao, n.d.). A Director in the North Carolina Justice Center, Al Ripley, noted that borrowers with ARMs “didn’t understand how the documents worked, they didn’t understand how the loans worked, and they were losing their homes because of it” (as cited in Zhao n.d.). Misleading marketing contributed to this phenomenon as it often downplayed the risks that were associated with adjustable rate mortgages (Zhao n.d.). 

Based on these facts alone, it is essential that an individual purchasing an adjustable rate mortgage be educated on the inner workings of the loan. In order to prevent a contribution to another housing crisis, borrowers must be prepared to pay accordingly based on an increase in rates after their fixed-rate period comes to an end. Despite this, ARMs can be a great fit for buyers who plan to move before their fixed-rate term ends. They are also an adept choice for buyers who believe interest rates will drop before their fixed-rate term ends, as it gives them an opportunity to refinance their home in the meantime (Campisi, 2023). As long as people are able to comprehend the risks of an adjustable rate mortgage and take no issue with uncertainty of future payments, ARMs are an adequate choice in the housing market today.

References

Adjustable-rate mortgage loans (arms) from Bank of America. Bank of America. (n.d.). https://www.bankofamerica.com/mortgage/adjustable-rate-mortgage-loans/#:~:text=Adjustable%2Drate%20mortgages%20(ARMs),rate%20goes%20up%20or%20down. 

Burns, T. (2023). Fed’s rate strategy stymied by stubborn housing cost inflation. The Hill. https://thehill.com/business/4290453-feds-rate-strategy-stymied-by-stubborn-housing-cost-inflation/#:~:text=%E2%80%9CThe%20impact%20of%20higher%20rates,wrote%20in%20a%20note%20Wednesday. 

Campisi, N. (2023). Is now a good time to get an arm?. Forbes. https://www.forbes.com/advisor/mortgages/is-now-good-time-to-get-arm/. 

Dehan, A. (2023). How federal reserve rate decisions impact arms, helocs. Bankrate. https://www.bankrate.com/mortgages/federal-reserve-decision-heloc-arms/. 

Olick, D. (2023). Adjustable-rate mortgage demand jumps nearly 10% as buyers struggle to afford housing market. CNBC. https://www.cnbc.com/2023/11/01/adjustable-rate-mortgage-demand-jumps-nearly-10percent-as-buyers-struggle-to-afford-todays-pricey-housing-market.html#:~:text=%E2%80%9CAs%20higher%20rates%20continue%20to,level%20in%20nearly%20a%20year. 

With an adjustable-rate mortgage (ARM), what are rate caps and how do they work?. Consumer Financial Protection Bureau. (2020). https://www.consumerfinance.gov/ask-cfpb/with-an-adjustable-rate-mortgage-arm-what-are-rate-caps-and-how-do-they-work-en-1951/#:~:text=Subsequent%20adjustment%20cap.,higher%20than%20the%20previous%20rate. 

Zhao, S (n.d.). Subprime lending. American Predatory Lending. https://predatorylending.duke.edu/business-analysis/evolution-of-mortgage-lending/subprime-lending/#:~:text=ARMs%20were%20not%20the%20sole,adjustable%2Drate%20mortgage%20delinquency%20rates.