Adjustable-Rate Mortgages

Definition

An adjustable-rate mortgage (ARM) is a type of mortgage loan where the interest rate is periodically adjusted based on a benchmark index. This allows the monthly payments to fluctuate over the life of the loan, unlike a fixed-rate mortgage where the interest rate remains constant.

5 Must Know Facts For Your Next Test

1. Adjustable-rate mortgages became more popular during the Great Deregulation Experiment, as they allowed lenders to offer more flexible and potentially risky loan products.
2. ARMs often feature an initial fixed-rate period, followed by periodic adjustments to the interest rate based on changes in the benchmark index.
3. The frequency of interest rate adjustments can vary, with common options being annual, semi-annual, or even monthly adjustments.
4. Borrowers with ARMs may benefit from lower initial interest rates compared to fixed-rate mortgages, but face the risk of higher monthly payments if interest rates rise.
5. Negative amortization can occur with certain ARM structures, where the monthly payments are insufficient to cover the interest due, causing the loan balance to grow over time.

Review Questions

• Explain how the introduction of adjustable-rate mortgages was related to the Great Deregulation Experiment.
  • The Great Deregulation Experiment in the 1970s and 1980s led to a relaxation of regulations in the financial industry, including the housing and mortgage markets. This allowed lenders to offer more flexible and potentially riskier loan products, such as adjustable-rate mortgages (ARMs). ARMs became more popular during this period as they enabled lenders to transfer interest rate risk to borrowers, potentially increasing their profits but also exposing borrowers to the risk of higher monthly payments if interest rates rose.
• Describe the key features of adjustable-rate mortgages and how they differ from fixed-rate mortgages.
  • The primary feature of an adjustable-rate mortgage is that the interest rate is periodically adjusted based on a benchmark index, such as LIBOR or the CMT. This allows the monthly payments to fluctuate over the life of the loan, unlike a fixed-rate mortgage where the interest rate remains constant. ARMs often have an initial fixed-rate period, followed by regular adjustments, which can be annual, semi-annual, or even monthly. This flexibility can be beneficial for borrowers when interest rates are low, but it also exposes them to the risk of higher monthly payments if rates rise. In contrast, fixed-rate mortgages provide more predictable and stable monthly payments, but may have higher initial interest rates.
• Analyze the potential risks associated with adjustable-rate mortgages, particularly in the context of the Great Deregulation Experiment.
  • The introduction of adjustable-rate mortgages during the Great Deregulation Experiment posed significant risks for borrowers. ARMs allowed lenders to transfer interest rate risk to borrowers, who faced the possibility of higher monthly payments if benchmark rates increased. This was especially problematic in the context of the deregulation, as it enabled lenders to offer more flexible and potentially risky loan products without the same level of oversight and regulation. Additionally, certain ARM structures, such as those with negative amortization, could lead to the loan balance growing over time, further exacerbating the financial burden on borrowers. The combination of deregulation and the increased availability of adjustable-rate mortgages contributed to the housing bubble and subsequent financial crisis, as many borrowers were unable to keep up with the rising monthly payments when interest rates increased.

Related terms

Fixed-Rate Mortgage: A mortgage loan where the interest rate remains the same throughout the entire loan term, resulting in consistent monthly payments.

Benchmark Index: The financial indicator, such as the London Interbank Offered Rate (LIBOR) or the Constant Maturity Treasury (CMT), that an ARM's interest rate is tied to and adjusted based on.

Negative Amortization: A situation where the monthly payments on an ARM are insufficient to cover the interest due, causing the loan balance to increase over time.