Variable mortgages may never come back
By sticking with a traditional 30-year fixed-rate mortgage, homebuyers could be paying more than they need to in a market where rates may be more likely to fall than rise over the next few years — or at least to stabilize.
But don’t bet on many owners who take that risk. In the United States, ARMs took precedence over 30-year fixed rate mortgages 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 usually entered into a contract known as a balloon loan with lenders including banks and wealthy individuals. These loans lasted only three or five years because state regulations did not allow long-term home loans. At the end of the term, borrowers had to disburse the entire principal. Payments, once small and manageable, would suddenly skyrocket – hence the name.
In reality, however, few people have repaid the loan in full. Instead, they would go back to the lender to negotiate and refinance with another balloon mortgage. They might do this several times before paying the principal in full.
This was a very crude version of a variable 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 was renewed during a period of high rates, the homeowner who could not afford to refinance had to pay the full balance immediately or face foreclosure.
This is precisely what happened after balloon mortgages peaked during the housing boom of the 1920s. When the Great Depression hit, the housing market crashed, 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 formed Home Owners Loan Company began providing long-term, low-interest, fixed-rate loans with smaller down payments. The Federal Housing Authority, created the following year, insured mortgages, while in 1938 Fannie Mae (the Federal National Mortgage Association) helped create a secondary market.
In 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 norm. Homeownership rates have skyrocketed.
But rising inflation and interest rates in the late 1960s and early 1970s put an end to this boom period. Credit unions on the front lines of mortgage lending have been locked into long-term, fixed-rate loans. As inflation continued to rise, their loan income could not keep pace with the higher rates they had to offer to attract short-term deposits.
So, as prices continued to rise in the early 1970s, a few S&Ls in California and Florida (which were not federally regulated) experimented with adjustable rate mortgages. Rates were lower than fixed-rate loans, but rose or fell with the market, reducing risk for 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 quickly rebuffed, even after the board proposed limiting rate increases to 2.5% regardless of inflation.
The rejection was largely due to the fury of trade unions and consumer organizations. Elizabeth Langer, executive director of the Consumer Federation of America, said that “raising interest rates would place a terrible burden” on Americans. AFL-CIO chief George Meaney threatened that “owners would have to demand higher wages and salaries to keep pace.”
But as inflation persisted, the Federal Home Loan Bank Board gave in, allowing adjustable rate mortgages in 1981. A Consumers Union spokesman condemned the move as an “abomination” and predicted that buying a house would turn into “Russian roulette”.
The hatred of ARMs was not irrational. Many consumer groups were concerned that potential buyers would settle for the lower initial rates and resent the risk of an increase in that rate.
Nonetheless, ARMs made up 68% of new mortgages in 1984, suggesting they were here to stay. Instead, their popularity proved to be fleeting as events turned in favor of the 30-year fixed rate mortgage.
First came complaints about adjustable rate mortgages. As they became more popular, mortgage lenders began to sell the loans in a way that left borrowers confused and, increasingly, angry. Newspaper articles quoting confused borrowers who were shocked that their rates went up — or in some cases didn’t go down even when interest rates fell — have become a staple of personal finance reports. .
Even the financial sector admitted there was a problem. As early as 1984, the chief executive of First Nationwide Financial Corp. was quoted in the Washington Post warning that interest rates were a “bait and switch” tactic that would backfire. The same article quoted a mortgage lender who candidly admitted to misleading borrowers: “We’d be happy to be upfront,” he noted, “but we wouldn’t get any loans that way.”
Other developments have conspired to halt the adoption of MRAs. By the early 1990s, interest rates had stabilized at lower levels, increasing the viability of fixed rate financing. The increasing complexity of ARMS has also put off borrowers: one study found more than 300 different types of ARM on offer. Faced with a classic version of the “paradox of choice,” many Americans have opted for the more secure and familiar fixed-rate mortgage.
Equally important has been the rise of securitization, which has spared undercapitalized lenders the risk of managing assets over 30-year periods. Although bundling mortgages into securities has a long history, beginning in the 1990s it became increasingly common for banks to offload fixed rate mortgages. ARMs, on the other hand, were more difficult to securitize, although the lower risks they posed to lenders made this less important.
ARMs enjoyed a brief renaissance on the eve of the 2008 financial crisis, but this was largely confined to the subprime market, with borrowers lacking the credit to exploit conventional fixed-rate mortgages. Inevitably, borrowers who flocked to ARMs turned out to be the most likely to default, and their mortgage defaults helped trigger a global financial crisis. Again, ARMs get bad press.
Perhaps the current painful wave of inflation, after such a long period of low interest rates and cheap mortgages, will entice more buyers to consider ARMs. But history suggests that Americans’ preference for 30-year fixed-rate mortgages, born in the depths of the Great Depression, is not going to change.
Perhaps for good reason – home ownership is much lower in other countries, largely due to their greater reliance on ARMs. Even at higher interest rates, the certainty offered by fixed rate mortgages in times of financial uncertainty can be worth the extra cost.
More other writers at Bloomberg Opinion:
Adjustable mortgage rush not the same as 2008: Alexis Leondis
What if the rental market was the first to break? : Conor Sen
Biden fails homeowners in inflation fight: Karl W. Smith
This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.
Stephen Mihm, professor of history at the University of Georgia, is co-author of “Crisis Economics: A Crash Course in the Future of Finance”.
More stories like this are available at bloomberg.com/opinion