Who Chose ARMs—and Why?

CUNA’s E-Scan Newsletter
June 16, 2010 | COMMENTS

The housing market meltdown created a landscape that credit union lenders know all too well: widespread loan delinquency, defaults, and foreclosures.

Adjustable-rate mortgages (ARMs) have been at the center of that financial storm, and they're the subject of a working paper from Harvard Business School that looks at causes of the housing market meltdown.

Though ARMs aren't new, the past decade saw new wrinkles in the product:

• Hybrid ARMs, which combine an initial fixed-rate period with a subsequent adjustable-rate period;
• Interest-only ARMs;
• Payment-option ARMs; and
• Negative amortization ARMs, with low payments in the initial years combined with a growing principal balance.

The expansion of borrower alternatives coincided with a period of rapid growth in homeownership and indebtedness. Between 1992 and 2004, according to data from the Federal Reserve Board:

• The rate of homeownership increased from 64% to 69%.
• The share of households with mortgages rose from 38% to 45%.

The expansion in alternatives was widely viewed as positive for borrowers. “American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage,” Alan Greenspan said in a 2004 speech at CUNA's Governmental Affairs Conference.

In spite of this optimism, the delinquency and foreclosure experience with respect to ARMs since 2004 has been poor. By the end of 2009, more than 40% of subprime ARMs were seriously delinquent. And among prime ARMs, the delinquency rate shot up from a low of 0.63% in 2005 to 18%.

This poor performance has raised questions about whether a substantial portion of borrowers failed to understand the terms of the ARMs they were taking out.

ARMs exhibited higher rates of foreclosure than fixed-rate mortgages, at least in the earlier stages of the mortgage crisis. At the end of 2007, ARMs represented 22% of mortgages outstanding but 62% of foreclosures. The high foreclosure rate suggests that households that took out ARMs in the years leading up to 2007 were more likely to be choosing a risky mortgage.

Other findings concerning households with mortgages:

• Higher income is associated with a higher likelihood of having a mortgage. Higher wealth, however, is associated with a lower probability of having a mortgage, as is higher age.
• Households that view interest rates as likely to rise are more likely to have mortgages on their homes.
• Starting in 2001, ARMs were often used by households that reported a lower probability of staying in their current home.
• Research finds the ARM market is split into two different submarkets—a high-income, wealthy segment and a low-income, credit-constrained segment. Choosing an ARM is more common among the credit constrained.
• Optimism also correlates with financial and other household decisions. Optimists and those who report more credit shopping—roughly half of households—are more likely to report having mortgages on their homes.