Adjustable-Rate Mortgages and Their Hidden Dangers

Read This Before You Get an Adjustable-Rate Mortgage

Image shows two images: a person walking into a home with boxes, and a person looking at a mortgage bill in shock. Text reads, "Pros and Cons of Adjustable Rate Mortgages," with text that reads, "these mortgages have lower rates so you can buy a bigger home for less; but monthly payments can rise if interest rates increase"

The Balance / Mary McLain

An adjustable-rate mortgage (ARM) is a loan that bases its interest rate on an index, which is typically the LIBOR rate, the fed funds rate, or the one-year Treasury bill. An ARM is also known as an "adjustable-rate loan," "variable-rate mortgage," or "variable-rate loan."

Each lender decides how many points it will add to the index rate as part of the ARM margin. It's typically several percentage points. For example, if the LIBOR is 0.5%, the ARM rate could be 2.5% or 3.5%. Most lenders will keep the rate at that advertised rate for a certain period. Then the rate changes at regular intervals. This is known as a "reset." It depends on the terms of the loan. Your mortgage reset date can occur monthly, quarterly, annually, every three years, or every five years, depending on the type of loan you get. You've got to read the small print carefully to determine whether you will be able to pay the higher interest rate.

The chart below illustrates the difference in ARM and LIBOR rates from 2005 through 2020.

After the reset, the rate will increase as LIBOR does. That means your money payment could suddenly skyrocket after the initial five-year period is up. If LIBOR were to rise to 2.5% during that time, then your new interest rate would rise to 4.5% or 5.0%. The historical LIBOR rate reveals that LIBOR increased in 2006 and 2007. It triggered many mortgage defaults that led to the subprime mortgage crisis.

You've got to pay attention to changes in the fed funds rate and short-term Treasury bill yields, because LIBOR typically changes in lockstep with it. Treasury yields rise when demand for the bonds falls.

LIBOR is in the midst of a regulatory phase-out that's set to be completed in mid-2023, so new ARMs won't use USD LIBOR as a reference rate after 2021 (in some cases, even earlier). The Secured Overnight Financing Rate is expected to replace USD LIBOR.

Key Takeaways

  • An adjustable-rate mortgage (ARM) is a home loan that starts out at an initially low rate, but after a certain period of time it will change based on an index rate, most often the LIBOR rate.
  • While an ARM can enable you to buy a more expensive house than you could buy with a fixed-rate mortgage, your house payments could skyrocket if interest rates rise.
  • Interest-only ARMs and option ARMs are other ways homebuyers can start out with low payments but end up with much higher payments down the road.
  • For most people, an ARM is not the best option when financing a home purchase.

Pros

The advantage of adjustable-rate mortgages is that the rate is lower than for fixed-rate mortgages. Those rates are tied to the 10-year Treasury note, which means you can buy a bigger house for less. That's particularly attractive to first-time homebuyers and others with moderate incomes.

Cons

The big disadvantage is that your monthly payment can skyrocket if interest rates rise. Many people are surprised when the interest rate resets, even though it's in the contract. If your income hasn't gone up, then you might not be able to afford your home any longer, and you could lose it.

Adjustable-rate mortgages became popular in 2004. That's when the Federal Reserve began raising the fed funds rate. Demand for conventional loans fell as interest rates rose. Banks created adjustable-rate mortgages to make monthly payments lower. 

Types

In 2004, bankers got creative with new types of loans to entice potential homeowners. Here are some examples of the most popular.

Interest-only loans. They have the lowest rates. Your monthly payment just goes toward interest, and not any of the principle, for the first three to five years. After that, you start making higher payments to cover the principle, or you might be required to make a large balloon payment.

If you are aware of how they work, these loans can be very advantageous. If you can afford it, any extra payment goes directly toward the principle. If you are disciplined about making these payments, you can actually pay more against the principle. That way, you will gain higher equity in the home than with a conventional mortgage. These loans are dangerous if you aren't prepared for the adjustment or the balloon payment. They also have all the same disadvantages of any adjustable-rate mortgage.

Option ARMs. They allow borrowers to choose how much to pay each month. They start with "teaser" rates of about 1% to 2%, which can reset to a higher rate, even after the first payment. Most option ARM borrowers make only the minimum payment each month. The rest gets added to the balance of the mortgage, just like negative amortization loans.

Borrowers think payments are fixed for five years. If the unpaid mortgage balance grows to 110% or 125% of the original value, the loan automatically resets. It can result in a payment that's three times the original amount. Steep penalties prevent borrowers from refinancing. As a result, most borrowers simply fall deeper into debt. Once the house is worth less than the mortgage, or the borrower loses a job, they foreclose.

These loans were a huge driver behind the subprime mortgage crisis. Option ARMs rose from 2% of all home loans in 2003 to 9% in 2006. Most of them defaulted. At least 60% were in California, where home prices fell by 40% from 2006 to 2011.

Article Sources

  1. Alternative Reference Rate Committee. "ARRC Applauds Major Milestone in Transition From U.S. Dollar LIBOR."

  2. Board of Governors of the Federal Reserve System. "Open Market Operations."

  3. Center for Responsible Lending. "Facts About 'Toxic Mortgages'—Payment Option ARMs."

  4. Financial Crisis Inquiry Commission. "The Financial Crisis Inquiry Report," Page 105.

  5. State of California Department of Justice. "Brown Calls on Banks and Loan Servicers to Detail Plans to Stem New Wave of Foreclosures."

  6. Public Policy Institute of California. "Just the Facts: California's Housing Market."