Most of us who watched the fallout of the housing crash of 2008 and subsequent Great Recession have heard that adjustable rate loans made by subprime mortgage lenders were to blame. Because of the crash, borrowers have been wary of adjustable rate mortgages (ARMs), but that is rapidly changing. It’s worth examining why ARMs are surging in popularity and how things have changed between 2008 and today so you’ll have a better understanding of today’s loan options.
Key Takeaways
- The market crash was in large part due to lax lending regulations and predatory lending practices
- Today, mortgage regulations and aggressive regulatory oversight create a safer lending environment for homeowners
- ARMs surge in popularity when interest rates are high because they are less expensive in the short term than fixed-rate mortgages
What is an adjustable-rate mortgage?
An adjustable-rate mortgage (ARM) is a type of home loan with a variable interest rate. When you choose an ARM, your initial interest rate is fixed for a brief period of time after closing. Afterward, your interest rate adjusts periodically, usually at monthly or yearly intervals. Some consider ARMs more risky because there’s a chance you’ll eventually pay a much higher interest rate than you can afford.
Why did the market crash in 2008?
To be able to talk about the features of today’s ARM loans, it’s useful to have context for why the 2008 housing crisis occurred. To put it simply, a significant percentage of the housing market (about 35%) consisted of ARMs, many of which were subprime loans.
A subprime mortgage is a housing loan made to borrowers with impaired credit records. Many of these borrowers did not qualify for conventional loans due to their poor credit. Subprime loans featured higher interest rates that were intended to compensate the lender for making a riskier loan. The initial interest rates offered on these loans was affordable, but the rate could change significantly over time, leading to an affordability crisis and foreclosure.
Other contributing factors to the crash included lack of income verification for borrowers who overestimated their monthly income and, therefore, their ability to repay, as well as negative amortization loans and interest-only loans. When the market crashed, many borrowers were upside down and had negative equity (their mortgage balance was higher than the home value at the time).
ARMs today are safer
There’s a huge difference between an ARM you may qualify for today and the ARMs offered prior to 2008. Both the government and financial institutions learned from past mistakes, instituting new regulations, policies, and controls that make an ARM much less risky today. However, improving lending laws does not totally eliminate risk. Mortgages are major financial commitments, and ensuring 1) you understand your loan terms before you take on a home loan and 2) you can afford the mortgage payment even if it eventually goes up are two other common areas of risk that are not addressed by tighter regulations.
That said, today’s ARMs do benefit from major improvements in lender underwriting systems and processes. Underwriters are the fact-checkers in the loan approval process. They verify that the financial picture painted in your loan application (your income, your debt, your credit history, etc.) is accurate and that you are a good candidate for the loan. In response to the crisis, there have been major technological and process overhauls to the tools and quality controls underwriters use to do their job.
Thanks to updates to truth-in-lending laws, the loan disclosures provided to you at all stages of the loan origination process are easier to understand than ever, and more transparent. Today, you would be much more informed about what you owe and how it will be repaid before signing closing documents.
These developments have created a much more robust, reliable loan approval process. When a borrower’s ability to repay a home loan is well-vetted, the likelihood of foreclosure decreases, although there are still some precautions to consider with ARMs.
Mortgage regulations have been tightened
One of the most familiar regulations is the Dodd-Frank Act, which made sweeping changes across all federal financial regulatory agencies and almost every part of US financial services. Its goal is to maintain financial market stability by mitigating risky lending practices and making financial services safer for consumers.
Dodd-Frank also created the Consumer Financial Protection Bureau (CFPB), a government agency whose goal is to prevent predatory lending practices and help borrowers fully understand the terms of a mortgage before agreeing to it.
Other rules, like the Ability-to-Repay/Qualified Mortgage Rule, set a higher bar for making a reasonable determination that you have the financial ability to repay the mortgage. These rules have a two-fold impact: first, they set more stringent requirements for lenders, which helps prevent predatory loan programs. Second, they result in new disclosure rules, which help you understand in clear and conspicuous terms how the loan will work and the true cost of the loan over time.
Why ARMs are popular again
Historically, ARMs are more attractive when interest rates are high because they generally offer lower initial rates than their fixed-rate counterparts. The difference can be substantial – the initial term on a 30-year ARM mid-2022 was 1% lower than a 30-year fixed rate mortgage. In 2022, we’ve seen a steady rise in interest rates, and a steady increase in ARM loans corresponding to that trend.
Additionally, ARM initial rate terms are longer than they used to be, making them more stable and less chaotic. You can easily find loans with initial terms of five, seven, or ten years. If you anticipate selling or refinancing in the next ten years, an ARM might save you thousands over a fixed-rate loan.
ARM rate caps
Buyers now have the additional protection offered by rate caps once their initial rate expires. Though they can be structured differently, here are three typical rate caps you may see in your loan application disclosures:
- Initial interest cap: the maximum the rate could increase after the initial fixed rate period.
- Annual adjustment cap: how much your interest rate could adjust each year.
- Lifetime cap: the maximum interest rate increase you could ever have.
Rate caps give peace of mind to homeowners for the long haul, no matter how market conditions change in the future.
Is an ARM a reasonable choice?
Today’s ARM comes with myriad safeguards you weren’t guaranteed in the 2000s, and ARMs can provide huge savings.
It’s all about balance and knowing what kind of loan is right for your financial situation. One thing is certain: ARMs today are not the scary loans they once were.