Adjustable-rate mortgages

Definition

Adjustable-rate mortgages (ARMs) are home loans where the interest rate can change periodically based on changes in a corresponding financial index that is associated with the loan. Typically, ARMs offer lower initial rates than fixed-rate mortgages, but they carry the risk of increasing payments in the future as interest rates rise. This characteristic of fluctuating rates can lead to affordability issues for borrowers, especially during economic downturns.

5 Must Know Facts For Your Next Test

1. ARMs typically start with a lower initial interest rate that may be fixed for a set period, often 3, 5, or 7 years, before adjusting based on market conditions.
2. The potential for payment increases can lead to financial strain for homeowners, particularly if their income does not keep pace with rising interest rates.
3. During the late 20th century, ARMs became popular as a way for lenders to offer lower initial payments to borrowers, which contributed to increased housing demand.
4. The savings and loan crisis in the 1980s and early 1990s was partially fueled by high levels of risky lending practices involving adjustable-rate mortgages.
5. Many borrowers were unprepared for the payment shocks that occurred when their loans adjusted upward after the initial fixed-rate period.

Review Questions

• How do adjustable-rate mortgages differ from fixed-rate mortgages in terms of borrower risks and benefits?
  • Adjustable-rate mortgages offer lower initial interest rates compared to fixed-rate mortgages, which can attract more borrowers looking for affordability. However, the primary risk associated with ARMs is that after the initial fixed period ends, rates may rise significantly, leading to higher monthly payments. In contrast, fixed-rate mortgages provide stability and predictability since borrowers know exactly what their payments will be over the life of the loan. This difference means that while ARMs can be beneficial in the short term, they can pose long-term risks if market conditions shift unfavorably.
• Discuss how adjustable-rate mortgages contributed to the savings and loan crisis of the late 20th century.
  • During the savings and loan crisis, many institutions engaged in risky lending practices by offering adjustable-rate mortgages to borrowers who may not have fully understood the implications of rising interest rates. As interest rates increased dramatically in the late 1970s and early 1980s, borrowers faced payment shocks that they could not afford, leading to widespread defaults. This situation placed significant financial strain on savings and loan associations that had heavily invested in ARMs, ultimately resulting in numerous bankruptcies and prompting government intervention.
• Evaluate the long-term implications of adjustable-rate mortgages on homeownership trends and economic stability.
  • The long-term implications of adjustable-rate mortgages on homeownership trends have been significant, especially in promoting access to housing during periods of low initial rates. However, this accessibility can come at a cost; when rates rise unexpectedly, many homeowners face financial distress or even foreclosure. This pattern creates a cycle where vulnerable populations are disproportionately affected by economic downturns. Additionally, widespread defaults on ARMs can contribute to broader economic instability by impacting housing markets and financial institutions reliant on mortgage-backed securities.

Related terms

Fixed-rate mortgage: A type of home loan where the interest rate remains constant throughout the life of the loan, providing predictable monthly payments.

Financial index: A benchmark used to determine changes in interest rates for adjustable-rate mortgages, such as the LIBOR or Treasury securities.

Subprime mortgage: A type of mortgage offered to borrowers with poor credit histories, often with higher interest rates due to the increased risk of default.