MLO Mentor: The adjustable-rate mortgage

MLO Mentor is an ongoing series covering compliance best practices for mortgage loan originators (MLOs). This article discusses the history of the adjustable rate mortgage (ARM) in the United States and how they work.

The birth of the adjustable-rate mortgage

In the United States, the most common type of home financing is the 30-year fixed-rate mortgage (FRM). Up until the early 1980s, the fixed rate mortgage was just about the only type of mortgage available to borrowers. Adjustable-rate mortgages were not yet authorized by federal regulators.

At the time, the main sources of mortgage funds were financial entities known as savings-and-loans. Savings-and-loans operated by offering depositors interest on their deposits (that’s the “savings” part), and in turn using the deposits to lend mortgage money at slightly higher interest rates (the “loans” part) than those paid to the depositors.

For instance, the savings-and-loans would pay a 5.5% interest rate to depositors, and then turn around and charge 6.5% to a mortgage borrower for a 30-year fixed rate mortgage. The savings-and-loans kept the spread between the two interest rates as profit, and continued the savings-and-loan cycle.

Prior to the 1980s, federal laws prohibited savings-and-loans from dabbling in other types of consumer finance, so their sole source of income was mortgage lending. The one-stop-shop mega banks we’re so familiar with today were unlawful then.

Thus, by their very structures, savings-and-loans were highly dependent on depositors’ funds as a source of funds to make loans and stay in business.

However, the loans made were 30-year fixed rate mortgages. A lender making a 30-year fixed rate mortgage is making a commitment to lend money at a fixed interest rate over a long period of time. Depositors, on the other hand, were being paid interest rates at market rates. This worked fine for the savings-and-loans while their expenses (the interest paid on deposits) were less than their income (interest rate charged on mortgage loans), but it left savings-and-loans highly vulnerable to interest rate fluctuations.

Congress attempted to mitigate this vulnerability in 1966 by placing caps on the amount of interest a savings-and-loan was able to pay to depositors. They set this cap higher than the cap placed on commercial banks to encourage depositors to place their money with savings-and-loans, to ensure the mortgage money continued to flow.

Then, economic conditions in the ‘70s drove inflation sky-high.

Savings-and-loans remained restricted by the interest rate cap. Other financial companies which were not subject to interest rate caps set by the federal government paid true market level interest. Savings-and-loans depositors began pulling funds from savings-and-loans in droves, to place their funds in higher-yield investments.

In an attempt to save the moribund savings-and-loans, Congress and regulatory agencies did two things in the early 1980s:

passed the Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA), which:
- allowed savings-and-loans to diversify their investments, (i.e., make money through means other than 30-year fixed rate mortgages); and
- removed interest rate caps on depositor funds; and
adopted regulations allowing savings-and-loans to offer adjustable-rate mortgage (ARMs).

In contrast to fixed-rate mortgages, ARMs allowed lenders to float interest rates to the market after a certain amount of time. By allowing mortgage rates to change according to the market, ARMs shifted inflationary and economic risk from the savings-and-loan to the borrower. Regulators hoped this would equalize the expenses and incomes of savings-and-loans, and pull them out of the red.

It didn’t work. Ultimately, savings-and-loans went the way of the dodo — but the ARMs remained. From 1980s and onwards, the ARM has been available to consumers. It has largely been as deleterious to uninformed borrowers as it was ineffective in rescuing savings-and-loans.

Editor’s note — The impact of ARMs on borrowers has been memorialized in some colorful language over the years. Veteran loan originators may remember when ARMs were called “topless mortgages” as it seemed their ceiling rates were set so high as to be meaningless. Other equally colorful names included the “Reverse Interest and Principal for Optimum Fast Foreclosure (RIPOFF) loan” and the “Zero Ability to Pay (ZAP) loan.”

Modern ARM twisting

The face of the ARM has changed over the years, most markedly during the Millennium Boom.

20 years after ARMs became part of the American mortgage landscape, the housing market was experiencing an unprecedented boom. Fueled by low interest rates and speculative fever, housing prices were skyrocketing. Mortgage lending standards are lax, in part due to demand from investors for ever more securitized mortgages, and in part due to the hubristic belief that prices would always rise, and therefore the collateral (the property), rather than the borrower, would carry the loan.

When demand for mortgages swelled mid-2005, Wall Street had perfected its vertically expanded system for gathering, bundling and reselling mortgages through the Mortgage-Backed Bond (MBB) market to millions of investors worldwide.

Of course, all these bonds were dependent on new mortgages. The most infamous of these new mortgage products were “subprime mortgages.” But the multitude of creative new types of ARMs were also created — or revived — during this era. If the borrower could not afford a mortgage, it was the mortgage’s fault, not the borrower’s!

In the history of adjustable-rate mortgages, FRMs guarantee a rate over a long period of time. Lenders necessarily build into the FRM interest rate the cost of keeping an interest rate “locked-in” at that interest rate for 30 years. ARMs tend to have lower initial rates because the initial “fixed rate” (if any) is shorter — a matter of a few months to a few years, rather than 30 years. Thus, otherwise unqualified borrowers were able to afford mortgages. ARMs offered low initial interest rates to qualify and very low payment schedule options for up to ten years.

Pre-pandemic ARM use was low thanks to comparable rates on FRMs, but that has changed rapidly. Borrowers who take out ARMs will be at the mercy of the rising interest rates of the next few decades.

In order to adequately inform borrowers of the impact ARMs may have on their payments, loan originators are best served by studying the context and history surrounding these products.

Next week, we’ll discuss the purpose, popularity, and elements of an ARM for Part Two.

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