In Defense of ARMs They're Neither 'Evil' Nor 'Toxic'

Introduction, and a few notes. Much of this four-part article was written in the wake of the housing market crash, but the arguments and facts here remain true even now. ARMs have an important role in the housing market landscape, and in certain market conditions such as those seen today, many potential homebuyers (and even some homeowners) may find themselves needing to consider an ARM instead of a fixed-rate mortgage.

It took a number of years, but the mortgage and housing crisis of the late aughts and early twenty-teens finally reached an inevitable conclusion. During those difficult times, mortgage shoppers were told all too often that Adjustable Rate Mortgages (ARMs) were either the cause of -- or at the heart of -- the housing market's failings, and put borrowers and lenders alike out on the street.

At the time, those claims had rattled their way across the political landscape as well, and the newly-formed Consumer Financial Protection Bureau for a time even considering banning all but "plain vanilla" mortgage products. As ARMs present different risks than do fixed-rate mortgages it's a safe bet that at least certain ARMs wouldn't have been included in any list of approved "vanilla" products.

However, arguments that ARMs are "evil" or "toxic" simply aren't supported by the facts. While it's true that most subprime mortgage products were ARMs and had a spectacular record of failure, and that even some 'prime' ARMs failed as well, it's also true that many ARMs didn't fail, and so may have even provided tremendous value to their holders.

It's also a fact that ARMs, in varying forms, had been a part of the residential mortgage marketplace for more than a quarter century at that point, and have been around nearly 40 years today. A mortgage product with this long of a history can't be all bad, or ARMs would have disappeared from the market. Certain varieties of ARMs -- even old standbys like the traditional one-year ARM -- have faded out the marketplace over time as consumers showed preference for other choices. Like every financial instrument, ARMs not applicable for everyone, or for every circumstance, nor do they always provide value to those who choose them.

It's important to note that ARMs were born of a need brought on by high interest rates. As they were developed, ARMs were based on the premise that borrower and lender alike should share the risks in an ever-changing interest rate climate. In exchange for accepting such risks, the borrower would benefit from a somewhat lower starting rate for a time, plus a chance at a lower interest rate in the future, and possibly lower interest rates which might persist for years. This is an important qualifier that you'll want to remember for later in this discussion.

The Product, or the Borrower?

While the forensics into the failure of certain ARMs went on for years, a distinction which needs to be made between the product itself and how it is or was utilized.

Suppose one needs to buy a vehicle. There are lots of choices, and all will get you from point A to point B. What type should one get? A buyer must decide what kind of vehicle best suits his or her needs, whether it is a sports car or a dump truck. It goes without saying that the two are meant for different purposes and aren't interchangeable, and a buyer selecting the wrong one will find an ill fit for their needs. This is also the case with financial products, including mortgages, which were developed to address certain time frames, needs and goals.

The oversimplified point is that some, if not many, of the problems with ARMs were not caused by the product, but rather by how it was applied relative to the user's needs or wants.

It's also worth noting that the sellers (salespeople) at our metaphorical car lot are interested in selling you something and will try to present you with as many choices as possible in order to make the sale. They can't make a living if they don't make sales, and for the most part, their role usually isn't to help you decide what kind of vehicle is right for you.

That said, we have always agreed that, if an ARM or any other mortgage borrower failed out of their loan due to circumstances beyond their control -- malfeasance, steering, predatory lending practices, whatever -- then let's expose and, if warranted, prosecute those bad mortgage actors to the fullest extent of the law. Conversely, to look to overly restrict or even ban access to a product which has proven to be helpful and useful to many hundreds of thousands - perhaps millions - of borrowers probably isn't the right solution.. Why penalize all borrowers, now and forever, for the failings of some of yesterday's? It just doesn't make sense.

Thankfully, ARMs weren't banned from the market. However, the Qualified Mortgage standards did ban some risky features that were overlaid onto ARMs, That's not to say things such as interest-only payments can't exist on ARMs; they can, but such ARMs can't be sold to Fannie Mae or Freddie Mac, and require the lender to accept and manage any risks and liabilities that might arise.

Value, and Opportunity

A product which offers a lower-than-market rate for a period of time offers both the promise of savings and an opportunity for homeownership which otherwise wouldn't have existed. Even if 50% of all subprime ARMs did fail (and some studies put it near those levels), that still left a 50% success rate -- and consequently, a lot of people had an opportunity to own a home who might not have become homeowners otherwise.

During the last boom, fixed-rate subprime loans were rare and expensive, with rates in the high-single- and low-double-digit range. For borrowers, a high interest rate restricts the size of the loan one can qualify for; for lenders, a high interest rate means a increased likelihood of the borrower refinancing at some point, so few lenders were interested in making them available, so they offered ARMs instead.

With this having been the case, it's also necessary to consider differences in mortgage borrowers.

Prime-quality borrowers have the ability to choose to select an ARM if it fits their needs; while at the time, borrowers with weak credit histories had little choice but to accept an ARM if they wanted mortgage credit. This is a crucial distinction as well, since a sizable chunk of the jumbo mortgage market -- loans made to the most well-off Americans -- were ARMs, and by the choice of the borrower. That was true then and is still true today.

Of course, there are no real subprime mortgage markets today. Now, underwriting standards are more traditional, meaning borrowers must be better qualified to borrow a mortgage, and Ability-to-Repay (ATR) rules require that lenders ensure that are better able to handle mortgage payments today and in the future, especially for ARMs.

Payments, and Risks

ARMs present a known risk that the borrower's payment will change in the future, and could be higher (increased risk) or lower (decreased risk). These risks can be plotted out and well-understood even before a borrower signs up for an ARM; it's pretty simple for most borrowers to do worst-case, best-case and likely-case scenarios for changes in interest rates using an amortization calculator.

It's also worth evaluating the various payment structures that were overlaid onto ARMs during the last boom to understand how these changed the risk profile of the product. Some payment methodologies compounded the risk of ARMs... but these were payment choices, not mortgage products.

A payment method which allows a borrower the chance to increase his or her loan balance by not repaying either principal or all of the interest that is accruing can have significant repercussions regardless of whether the product has a fixed interest rate or not. This "negative amortization" represents a kind of increasing leverage over time, and ultimately this deferment of cost comes due. Borrowers whose ARMs allowed for negative amortization weren't required or compelled to choose this option; even PayOption ARMs allowed the choice of a fully-amortizing payment, but it was up to the borrower to make it.

Payments which require only interest for some period of time also have well-understood implications when they change to include the payment of principal (that is, when they become fully-amortizing). For the most part, these are knowable outcomes; deferring payment necessary to amortize the debt -- let alone not even paying all the interest which is due -- can cause borrowers trouble when increases in the required payment occur, whether the underlying mortgage product is fixed or adjustable. That the product might also have a rising or even considerably higher interest rate at the time when required fully-amortizing payments kicked in compounds this risk.

Whether anybody took the time to discuss these considerations and outcomes with borrowers when the product was being originated is a discussion for another day; both lenders and borrowers have responsibility in this regard. However, we should keep in mind that available choices of payment methods aren't themselves mortgage products -- these were or are options that could be added to any loan, just as power windows can be added to any vehicle. It's to those options, then, that the regulatory and legislative focus should have turned, and largely did -- and also rightly focused on having lenders properly qualify borrowers ability to repay the loans they were taking.

At the time, consumer protection discussion centered on whether the public would benefit from a regulation that residential first mortgage loans must not allow for negative amortization -- or, perhaps, that the borrower must be qualified on the required fully-amortizing payment for the remaining term. The QM standard covered the vast majority of typical mortgage borrowers and closed the secondary markets for these kinds of payment choices, so neg-am ARMs don't really exist today. However, interest-only products live on in non-QM markets, available to niche borrowers with certain needs or goals. As well, lenders generally employ much more rigorous underwriting standards to evaluate borrowers today, all to help ensure that the borrower can afford the loan under any realistic scenario.

It's our opinion that homes and mortgages should never be sold solely on the basis of monthly payment alone. Of course, for a time, that's exactly what happened. Promising a starry-eyed prospective homebuyer the chance to own a $400,000 five-bedroom colonial in the tony part of town for only a few hundred bucks per month was irresponsible, especially if that low, low payment lasted for just perhaps six months before the payments could increase.

For a time during the last boom, borrowers who wanted or needed to stretch their incomes to the limit just to qualify for the initial payment (or who were allowed to leverage their incomes into extra-large mortgages) were among those folks who shouldn't have got an ARM -- or, perhaps, any mortgage -- as any future increase in any monthly obligation would have seen them teetering on the edge of fiscal solvency.

There's also something to be said about the frequency of interest rate changes on ARMs; even some venerable products are fading from the market as consumer interests have changed over time. Short-term ARMs -- those with up to a one-year interest rate change frequency -- have, at times, caused borrowers trouble in periods of quickly rising interest rates, as they can produce ever-higher monthly payments in rapid succession. There are good reasons why borrowers have gravitated to hybrid ARMs with longer delays before the initial adjustment occurs; chief among them is the stability of the monthly payment for at least a reasonable time horizon (or for a desired time period).

ARMs when rates are high

As noted earlier, ARMs were developed in a time when fixed-rate mortgages (FRMs) were prohibitively expensive. Rates were well into the double digits in the early 1980s, and few borrowers were interested in locking in those high rates for a full 30 years, even if they could qualify for them. The earliest ARMs didn't offer any discount on the initial rate -- no 'teasers' here -- but instead the opportunity that your mortgage rate and monthly payment would decrease as market interest rates returned toward more normal levels.

Because of this, ARMs can be a very good and valuable choice when interest rates are high, because there is an opportunity for the borrower to benefit, perhaps significantly, when interest rates decline from their peaks.

Homeowers who held onto their ARMs during the housing bust and well into the recovery discovered this when the short-term interest rates that govern ARMs fell to near zero and remained there for years.

ARMs when rates are low

Of course the reverse is also true. When interest rates are low -- at or close to historical lows as they have been on multiple occasions since 2008 -- the only way they can actually move is upward. At times when they might be considering an ARM, we wonder how many homebuyers asked their lender: "With interest rates at or near rock-bottom levels, why should I get a mortgage whose interest rate is far more likely to rise than fall?" Conversely, how many lenders would discuss this with their borrowers? During the last boom, was there no realization -- on either side -- that interest rates may not (or couldn't) get much lower, and that higher monthly payments were all but a certainty?

During the mid-aughts housing boom we often wondered about the evident mania, which fostered a "buy a house at any cost" kind of mentality. There's much, much more to homeownership beyond "Can I afford today's monthly payment?" Since owning a home is generally a longer-term prospect than, say, a car lease, the proper question to ask is "Will I be able to afford tomorrow's obligations?" At the very least, worries about making payments far into the future was a concept which used to keep prospective homebuyers awake at night. During boom times? Not so much.

The housing market in which we find ourselves today is rather different than previous ones, but with record-high home prices and comparatively (although not historically) high fixed-rate mortgages, borrowers considering an ARM today might do well to ask themselves this question again.

Who else might benefit?

As noted above, so there's at least one audience for whom ARMs are a valuable component. Are there others? Certainly.

Buying a small apartment but planning on a growing family within a handful of years? Why pay the cost for a fixed rate for a full 30 years when you plan on moving up within a few years? Various fixed-rate periods available on ARMs means you can get all the fixed rate (and level payments) you might ever want or need without the expense of buying a full 30 years' worth of fixed payments.

Closing in on retirement age, and thinking of decamping your current location in the fairly near future, while wondering how you'll generate cash to more fully fund your retirement accounts? Let's say that you have a five-year window until retirement is likely to occur; recasting your remaining loan into an ARM -- even a "risky" interest-only payment model -- can maximize your cash flow and serve to secure your retirement to a greater degree.

Before you laugh, consider this: A $200,000 6.5% loan taken 10 years ago by a 52-year-old would carry a monthly payment of $1,264 -- and that payment will remain constant until the home is slated to be sold (five years in the future).

A refinance to a 5/1 interest-only ARM at 5% would see that payment, for the next five years, drop to just $706 per month, adding more than $550 per month to cash flow until the borrower is 67 years old and ready to sell or /retire. True, the borrower wouldn't be building any more equity (excepting any home-price appreciation) but the cash-flow improvements are impressive and potentially valuable.

Even if the payment is a fully-amortizing one ($910 per month), this still produces better than a $350 per month improvement in cash flow, while paying off some $14,000 of the outstanding balance over the next five-year period, to boot. Of course, part of the cash-flow improvement comes from re-setting the "amortization clock" back to 30 years.

We could probably come up with a few more audiences who need of could utilize various ARMs to good effect... but you should have the idea by now.

What to do if inflation spikes?

Although the final rules of the Dodd-Frank Act didn't specifically ban ARMs in favor of "plain vanilla" mortgages, it did create QM and non-QM structures and produced risk-retention rules for those who securitize non-QM mortgages, including ARMs. The mortgage-market infrastructure that supported securitization of all manner of mortgages back in the last boom largely disappeared since then, and so-called "private label" securitizations of mortgages dried up.

As a result, and for the most part, ARMs returned to their more traditional roots as being available solely from depository institutions (banks, credit unions) who could make them profitably on a one-off or occasional basis.

At the same time, low interest rates for fixed-rate mortgages saw consumers shift back toward more traditional mortgages choices, so ARM volumes dropped back to very low levels, where they remained for years. As there were few to be made and the risk of making them needed to be managed in portfolio, these (and other) factors led many lenders to abandon offering ARMs. This trend was already evident, to a smaller extent back in 2008. A large number of lenders -- perhaps most -- simply said "We don't offer those products anymore."

Worried about excessive regulatory burden, smaller lenders in particular expressed concerns that such too-stringent restrictions would rob them of their ability to meet their customers' needs. Although there might be some consumer advocates and legislators who would have approved of the disappearance of ARMs, we again must point out that ARMs present their greatest value when fixed interest rates are relatively high -- a threshold as low as perhaps 7%, give or take a little.

Rates as high as this haven't been seen in many years -- in fact, not since 2002 -- but with inflation running at or close to 40-year highs there is a reasonable chance they might reemerge in the coming years. If so, homebuyers and even homeowners looking to refinance will need to turn again to ARMs for more affordable financing options.

The coming (and ongoing) need for ARMs

Even with a sizable increase in a short period, mortgage rates are still historically pretty low. We can say with 100% certainty that this will not always be the case. While no one knows how high interest rates may go during an economic or inflationary cycle, there is growing evidence that "pull-out-all-the-stops" of both monetary and fiscal policy employed to cushion the pandemic-caused economic downturn has turned into a nasty spike in inflation that may persist for a time.

An inflation spike will push up interest rates, particularly long-term interest rates -- like those found on, say, 30-year FRMs. The housing market is highly sensitive to interest rate changes, and low fixed interest rates have been a key component for the recovery of housing and the subsequent hot housing markets we have seen in recent years. But what would happen to the housing market if interest rates visit 7% or 8% -- or even approach 9%, as they did before the last housing boom got underway?

Absent ARMs, how severe might be a collapse in home sales?

As "affordability" is the intersection of a home's price and financing costs, how much might demand for housing and home prices be crushed (again) with fixed-rate mortgages at 7% or 8% and no lower-cost options available? The difference in the amount of mortgage you can borrow at 6% versus 8% is substantial, and the housing market can only function if borrowers can afford to buy. If ARMs didn't exist, there would be few or no lower-cost mortgage options available, and the market would probably come to a near-complete halt until either incomes rose or prices fell... or more likely, a combination of both over time.

It's also worth considering that ARMs can be a useful tool for spurring the housing market, too. During the last period of slack demand for newly-built homes, builders needed to move inventory. To spur sales, a major national home builder began offering a 7/1 ARM with an interest rate that was more than a percentage point and a half below conforming 30-year FRMs to buyers of its houses.

Over a period of seven risk-free years, a borrower who took that 7/1 ARM over the then-comparable 5.5% 30-year FRM with a $250,000 loan amount saved some $244 per month -- about $28,000 in total interest costs over 84 months -- while also retiring some $7,500 more of the loan's principal balance over that time compared with the 30-year FRM. Importantly, and the loan's interest rate wasn't slated to come to an adjustment point until 2017.

ARM critics of course noted that "anything can happen after that!", and to a degree, that's true. However, nothing prevented the borrower from refinancing out of that ARM without penalty at any time... and it's also quite possible that the borrower will have closed out the loan by moving, too. "Anything can happen!" is true, but we'd also like to see even a grudging acknowledgment that there may be positive, risk-free outcomes, too. As the risks are knowable, they might even be ameliorated to a great degree with a little bit of disciplined planning on the borrower's part. In the case of the example above, significant refinancing opportunities came along in 2012 and again in 2016... and of course, more recently, when fixed-rate mortgages hit all-time lows, so a borrower might have enjoyed a low, risk-free rate for anywhere from 2 to 6 years before opting out, and possibly longer.

With ARMs, each rate reset (whether up or down) is applied against the remaining balance, and for fully-amortizing ARMs, this helps to limit cost increases even if rates have moved up or helps lower payments even further if rates have gone down.

How many ARMs succeeded over the years?

While critics are quick to point out how many ARMs have failed in this "perfect storm" of loose lending policies at a time of rock-bottom interest rates, the fact is that many ARMs did not. There probably have been many millions of success stories over the 40-year history of the product, and many homebuyers and refinancers have enjoyed opportunities for homeownership and saving money that ARMs have provided.

Still think they're "toxic"?

A wide range of available choices in mortgage financing benefits everybody. It serves to help promote housing demand, which keeps home values firmer than they would otherwise be. At their core, ARMs remain valuable to specific audiences who can and have used them to great effect over the years. In this way, they are a 'niche', product, no different than any other 'niche' product. It is only when the those outside the 'niche' either stumble or are crammed into it does it create a problem, for lender and borrower alike. It is a fact that certain mortgage choices are intended to fit certain applications, and regardless of the product, issues will arise when an improper choice is made.

While we don't think ARMs are toxic or evil, we would agree that there can always be a better, clearer and simpler ways of disclosing how a given product will work -- in best-, typical- and worst-case scenarios. We think loan documents need to be much more explicit in how a borrower might be harmed, particularly if an ARM is coupled with any form of non- or partially-amortizing payment method. We think that no mortgage should be sold solely on the basis of initial monthly payment, let alone see borrowers qualified at artificially-low interest rates.

However, we do believe in mortgage choice, albeit informed choice, and we do believe that innovation and evolution of mortgage products matters. Just as certain products in the mortgage markets have come and gone -- due to consumer and lender choice (two-step balloons, anyone?) -- we think which products survive and which do not should occur as part of that natural process of the marketplace weeding the useful from those which are not. We would hate to see innovation or consumer choice quashed by regulators over-reaching in the name of "consumer protection".

For more about how ARMs work, you'll want to check out HSH's comprehensive Guide to Adjustable Rate Mortgages.