Variable Mortgages May Never Make a Comeback

Variable Mortgages May Never Make a Comeback

Adjustable-rate mortgages, or ARMs, have a bad reputation with homebuyers who have long viewed them as a dangerous financial trap. But with rates on fixed-rate mortgages more than doubling in 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 if you believe rates are nearing their peak.

By sticking to a traditional 30-year, fixed-rate mortgage, homebuyers could be paying more than necessary in a market where rates may be more likely to move down than up in the next few years — or at least level off.

But don’t bet on many homeowners taking that risk. In the US, ARMs have taken a backseat to the 30-year, fixed-rate mortgage for many decades. And if you look at Americans’ experience with long-term financing, you see why that’s unlikely to change now.

In the 1800s, anyone who wanted to borrow money to buy farmland or a house typically entered into a contract known as a balloon loan with lenders that included banks and wealthy individuals. These loans only ran for three or five years because state regulations didn’t permit long-term real-estate loans.  At the end of the term, borrowers had to fork over the entire principal. Payments, formerly modest and manageable, would suddenly balloon — hence the name.

In reality, though, few people paid off the loan in full. Instead, they’d go back to the lender to negotiate and refinance with another balloon mortgage. They might do this several times before discharging the principal in its entirety.

This was a very crude version of an adjustable-rate mortgage: Market forces determined the interest rate each time the borrower took out a new loan. And therein lay a serious problem. If the mortgage rolled over during a period of high rates, the homeowner who couldn’t afford to refinance had to pay the whole balance immediately or face foreclosure.

That’s precisely what happened after balloon mortgages reached peak popularity in the housing boom of the 1920s. When the Great Depression hit, the property 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 created Home Owners’ Loan Corporation began making low-interest, fixed-rate, long-term loans with more modest down payments. The Federal Housing Authority, chartered the following year, insured mortgages, while in 1938, Fannie Mae (the Federal National Mortgage Association) helped create a secondary market.

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

But rising inflation and interest rates in the late 1960s and early 1970s put an end to this halcyon period. The savings and loans associations on the front lines of mortgage lending were locked into long-term, fixed-rate loans. As inflation kept rising, their loan revenue couldn’t keep pace with the higher rates they needed to offer to attract short-term deposits.

So as prices kept rising in the early 1970s, a few S&Ls in California and Florida (who weren’t subject to federal regulations) experimented with adjustable-rate mortgages. The rates were lower than fixed-rate loans, but they rose or fell with the market, reducing risk for the lenders.

These forays inspired policymakers at the Federal Home Loan Bank Board to conclude that variable mortgage rates were the wave of the future. They asked Congress to sanction the idea, but they were swiftly rejected, even after the board offered to limit rate increases to 2.5%, regardless of inflation.

The rejection was largely due to the fury of unions and consumer organizations. Elizabeth Langer, executive director of the Consumer Federation of America, declared that “to have the interest rate soar upward would place a terrible burden” on Americans. George Meaney, head of the AFL-CIO, threatened that “homeowners would have to demand higher wages and salaries to keep up.”

But as inflation persisted, the Federal Home Loan Bank Board relented, allowing adjustable-rate mortgages by 1981. A Consumers Union spokesperson condemned the move as an “abomination” and predicted that buying a home would turn into “Russian roulette.”

The hatred of ARMs wasn’t irrational. Many consumer groups feared that prospective homebuyers would fixate on the lower “teaser” initial rates and fail to appreciate the risk of that rate rising.

Nonetheless, ARMs constituted 68% of new mortgages in 1984, suggesting they were here to stay. Instead, their popularity proved fleeting as events turned back in favor of the fixed-rate, 30-year mortgage.

First came the complaints about adjustable-rate mortgages.  As they became more popular, mortgage lenders began selling the loans in ways that left borrowers confused and, increasingly, angry. Newspaper articles quoting befuddled borrowers who were shocked that their rates had gone up — or in some cases that they’d failed to go down even when interest rates declined — became a staple of personal finance reporting.

Even the financial sector admitted that there was a problem. As early as 1984, the chief executive of First Nationwide Financial Corp. was quoted in the Washington Post warning that teaser rates were a “bait-and-switch” tactic that would backfire. The same article quoted a mortgage lender who candidly admitted misleading borrowers: “We would be happy to be straightforward,” he noted, “but we wouldn’t get any loans that way.”

Other developments conspired to arrest adoption of ARMs. By the early 1990s, interest rates had stabilized at lower levels, increasing the viability of fixed-rate financing. The growing complexity of ARMS also turned off borrowers: One study counted upward of 300 different types of ARMs on offer. Confronted with a classic version of the “paradox of choice,” many Americans opted for the safer, and more familiar, fixed-rate mortgage.

Equally important was the rise of securitization, which spared undercapitalized lenders the risk of managing assets over 30-year time periods. Though bundling mortgages into securities had a long history, from the 1990s onward it became increasingly common for banks to offload fixed-rate mortgages. ARMs, by contrast, were more difficult to securitize, though the lower risks they posed to lenders made that less important.

ARMs enjoyed a brief renaissance by the eve of the financial crisis of 2008, but this was largely confined to the subprime market, with borrowers who didn’t have the credit to tap conventional fixed-rate mortgages. Inevitably, the borrowers who flocked to ARMs happened to be the most likely to default, and their failure to pay their mortgages helped spark a global financial crisis. Once again, ARMs got a bad rap.

Perhaps the current painful wave of inflation, following 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, born in the depths of the Great Depression, isn’t going to change.

Perhaps for good reason — homeownership is much lower in other countries largely because of their greater reliance on ARMs. Even at higher interest rates, the certainty offered by fixed-rate mortgages in uncertain financial times may be worth the extra cost.

More From Other Writers at Bloomberg Opinion:

Adjustable Mortgage Rush Isn’t the Same as 2008: Alexis Leondis

What If the Rental Market Is the First to Break?: Conor Sen

Biden Is Failing Homeowners in Inflation Fight: Karl W. Smith

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Stephen Mihm, a professor of history at the University of Georgia, is coauthor of “Crisis Economics: A Crash Course in the Future of Finance.”

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