Will variable mortgages make a comeback

Adjustable-rate mortgages, or ARMs, have a bad reputation with homebuyers who have long viewed them as a dangerous financial trap. But with rates on fixed-rate mortgages more than doubling in the past year, some borrowers are taking a second look. The idea of paying less now in exchange for the risk of paying more later seems reasonable if you believe rates are nearing their peak.
By sticking to a traditional 30-year, fixed-rate mortgage, homebuyers could be paying more than necessary in a market where rates may be more likely to move down than up in the next few years — or at least level off.
But don’t bet on many homeowners taking that risk. In the US, ARMs have taken a backseat to the 30-year, fixed-rate mortgage 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 typically entered into a contract known as a balloon loan with lenders that included banks and wealthy individuals.
These loans only ran for three or five years because state regulations didn’t permit long-term real-estate loans. At the end of the term, borrowers had to fork over the entire principal. Payments, formerly modest and manageable, would suddenly balloon — hence the name.
In reality, though, few people paid off the loan in full. Instead, they’d go back to the lender to negotiate and refinance with another balloon mortgage. They might do this several times before discharging the principal in its entirety.
This was a very crude version of an adjustable-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 rolled over during a period of high rates, the homeowner who couldn’t afford to refinance had to pay the whole balance immediately or face foreclosure.
That’s precisely what happened after balloon mortgages reached peak popularity in the housing boom of the 1920s. When the Great Depression hit, the property market collapsed, 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 created Home Owners’ Loan Corporation began making low-interest, fixed-rate, long-term loans with more modest down payments. The Federal Housing Authority, chartered the following year, insured mortgages, while in 1938, Fannie Mae (the Federal National Mortgage Association) helped create a secondary market.
By 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 standard. Homeownership rates soared.
But rising inflation and interest rates in the late 1960s and early 1970s put an end to this halcyon period. The savings and loans associations on the front lines of mortgage lending were locked into long-term, fixed-rate loans. As inflation kept rising, their loan revenue couldn’t keep pace with the higher rates they needed to offer to attract short-term deposits.
So as prices kept rising in the early 1970s, a few S&Ls in California and Florida experimented with adjustable-rate mortgages. The rates were lower than fixed-rate loans, but they rose or fell with the market, reducing risk for the 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 swiftly rejected, even after the board offered to limit rate increases to 2.5%, regardless of inflation.
The rejection was largely due to the fury of unions and consumer organizations. Elizabeth Langer, executive director of the Consumer Federation of America, declared that “to have the interest rate soar upward would place a terrible burden” on Americans.