What is an Adjustable Rate Mortgage (ARM)?

During the mid-2000s, the Federal Reserve began to raise the federal funds rate. As these interest rates increased, the demand for conventional loans began to fall. Considering that the banks were churning out mortgages left and right and pushing the housing boom, they needed to develop another type of loan that would curb these interest rate increases. This is when the adjustable-rate mortgage was presented to the public in 2004. Adjustable-rate mortgages became very popular leading to the financial crisis, as they were enticing due to their multi-year low-interest rates and lack of income and credit verification at the time. As well all know, in 2007-2008 the housing market reached an unsustainable bubble that triggered the 2008 financial crisis – and ARMs accounted for more than 50% of mortgages in 2005, 2 years before the crisis started in 2007. 

Adjustable-rate mortgages (ARMs) were very popular during the housing boom as they avoided federal funds interest rate increases – for the short term. ARMs will generally come in three forms: hybrid, interest-only (IO), and payment options. Hybrid ARMs establish a fixed, low-interest rate for a few years before implementing a new variable interest rate that will change at an established date. The new interest rate could incrementally increase over a timeframe, ranging from months to years. The interest-only (I-O) ARM establishes terms stating that a borrower only pays the interest on a mortgage for a specified timeframe before paying both interest and the principal on the loan. 

The last ARM type is the payment-option ARM, an option that includes several payment options. These payment options include paying down principal and interest, just paying the interest, or paying a minimum every month. The payment option ARM is a loan type that sounds enticing in the short term, but it is important to keep in mind that the specified amount that needs to be paid back will need to be paid back in full within the lender’s terms. This could lead to skyrocketing payments down the road as the end of the terms gets closer. Adjustable Rate Mortgages (ARMs) may be a smart financial decision if you are planning to keep the loan for a limited amount of time or will be able to handle any increases in interest rates, but overall this loan type has become one of the least popular today due to their contribution to the 2008 financial crisis.