The Decline of Adjustable-Rate Mortgages in 2010

The popularity of adjustable-rate mortgage (ARM) loans has declined sharply since the housing boom. This is partly because home buyers today are more aware of the risks associated with ARM loans.

Money HouseAt the height of the housing boom, adjustable-rate mortgages were about one-third of the mortgage market. They also accounted for roughly 80 percent of subprime loans. By 2008, ARM loans only accounted for about 15 percent of mortgage activity.

Today, as we move into 2011, adjustable-rate mortgages are only 5 – 6 percent of the market. That’s a huge decline, and it’s evidence of the growing stigma of the ARM loan.

How Does an Adjustable-Rate Mortgage Work?

Most adjustable-rate mortgages in use today are actually “hybrid” loans. This means they start with a fixed interest rate for a certain period of time, usually one to five years. After this initial period, the interest rate on the loan will begin to adjust or “reset” at some predetermined interval.

For example, the 5/1 ARM loan carries a fixed interest rate for the first five years, after which the rate will adjust every year. That’s what the “5/1” numbers signify. Adjustable-rate mortgages usually have caps that limit how much the rate can increase from one adjustment to the next, and also over the life of the loan.

Learn more about ARM loans.

A Brief History of ARM Loans

In 1982, during the Reagan administration, the U.S. Congress passed the Alternative Mortgage Transactions Parity Act (AMTPA). This legislation allowed non-federally chartered mortgage lenders to offer adjustable-rate mortgages. Before the passage of this act, banks were mostly limited to making conventional fixed-rate mortgages.

This legislation also paved the way for balloon loans, option ARM loans, negative amortization loans, and other so-called “exotic” mortgages. In more recent years, this act has been criticized for allowing lenders to obscure the total cost of a loan (and here the term “fuzzy math” comes to mind).

Adjustable-rate mortgages gained popularity through the latter half of the 1980s. In the mid 90s, when the housing boom was heating up, ARM loans exploded in popularity. At the height of the boom, one in three mortgage loans came with an adjustable rate. Through 2011, however, these loans will probably only account for about 5 percent of total mortgage applications.

Unpredictable in the Long Term

The risk associated with adjustable-rate mortgages comes during the first adjustment period, and every adjustment thereafter. Even if the rate is fixed for the first five years, it’s going to start changing eventually. In most cases, the rate will adjust upward to follow some kind of index. If the initial interest rate is heavily discounted, then the rate may rise significantly down the road. Save now … pay later. This kind of unpredictability makes the ARM loan a bad choice for a long-term stay.

When to Consider Using an Adjustable Mortgage

There is only one scenario when I recommend using an adjustable-rate mortgage. That’s when you know for sure that you’ll only be in the home for a few years. If you plan to sell the house and move after a few years, you could avoid the uncertainty of the first adjustment period. So, if you can get a lower initial rate with an ARM loan than a fixed mortgage, it might be in your interest to use one.

The key is to understand how these loans work, and what risks they carry. What happens if you’re unable to sell the home for some reason? Can you afford the new payments after the loan adjusts? You need to answer these questions before making a decision.