Mortgage Concepts is a recurring video series covering best practices and compliance education for California mortgage loan originators (MLOs). This video is the first of a 2-part series explaining the history of the adjustable rate mortgage (ARM). For Part 2, subscribe to firsttuesday’s newsletter, Quilix.

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When mortgage became adjustable

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 FRM was just about the only type of mortgage available to homebuyers.

At the time, the main sources of mortgage funds were financial entities known as savings-and-loans (S&Ls). S&Ls operated by offering depositors interest on their deposits (the “savings” part). In turn, they used the deposits to lend as mortgage money at higher interest rates (the “loan” part) than those paid to the depositors.

For example, the S&L would pay a 5.5% interest rate to their creditors, the depositors. Then, the S&L charged a homebuyer 8.5% for a 30-year FRM. The S&L used the spread between the two interest rates — their margin — to cover operating costs and generate a profit to continue the S&L cycle.

Prior to the 1980s, federal laws prohibited S&Ls 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, S&Ls were highly dependent on obtaining depositors’ savings as a source of funds to originate mortgages and stay in business.

However, a lender originating a 30-year FRM makes a commitment to lend money at a fixed interest rate over a long period of time. Depositors, on the other hand, were paid interest at market rates, which fluctuate daily.

Everything worked fine for the S&Ls in the 1950s and early 1960s while their expenses (the interest paid on deposits) were less than their income (the interest rate charged on mortgages). But these divergent financial commitments left S&Ls highly vulnerable to interest rate fluctuations as the trend in market rates began to rise going into the 1960s.

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Congress attempted to first mitigate this vulnerability in 1966 by placing caps on the amount of interest a S&L was able to pay to depositors at a time when market interest rates were on a steady rise, which continued until interest rates peaked at the end of 1982. The cap rate was set higher than the cap placed on commercial banks to encourage depositors to place their money with S&Ls, to ensure the mortgage money continued to flow.

Then, economic conditions in the ‘70s worsened, driving inflation sky-high due primarily to lack of diligence by the Federal Reserve. Meanwhile, S&Ls remained restricted by the cap on interest rates they paid depositors.

Other financial companies which were not subject to interest rate caps set by the federal government paid money-market level interest. S&L depositors began pulling funds from S&Ls in droves, to place their funds in higher-yield investments opportunities.

Consumers take on risks

In an attempt to save the moribund S&Ls, Congress and regulatory agencies did three things in the early 1980s:

  • passed the Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA), which:
    • allowed S&Ls to diversify their investments, i.e., make money through means other than 30-year FRMs by a preemption of state laws to the contrary; and
    • removed interest rate caps on depositor funds, which evolved into money market accounts;
  • adopted regulations allowing S&Ls to offer ARMs; and
  • allowed mortgage holders to call a loan on the property owner’s transfer of any interest in the property, whether by sale (due on sale), by further encumbrance (second trust deeds) or leasing with a term over three years or with options to buy, which then permitted mortgage lenders to demand an adjustment in the FRM and ARM note rates to current market rates and exact a fee in a waiver-modification process; and
  • permitted originations of alternative mortgages that proved very problematic in the late 1980s. [Garn-St Germain Depository Institutions Act of 1982]

In contrast to FRMs, ARMs allowed S&Ls to periodically adjust mortgage rates to market rates. By allowing ARM rates to change in concert with rates in the money market, ARMs shifted inflationary and economic risk from the S&L to homebuyers. Regulators hoped to equalize the expenses and incomes of S&Ls, and pull them out of the red.

It didn’t work. Ultimately, S&Ls went the way of the dodo as they converted themselves into banks, but ARMs remained as a trophy for their efforts. From the 1980s onward, the ARM has been available to consumers. Worse, it has largely been as deleterious to uninformed homebuyers as it was ineffective in rescuing S&Ls. A collective misunderstanding of economics, and maybe just math.

Editor’s note — The impact of ARMs on homebuyers has been memorialized in some colorful language over the years. Veteran mortgage 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) mortgage” and the “Zero Ability to Pay (ZAP) mortgage.”

Related charts:

Trending mortgage rates