Expert Commentary

Adjustable-rate mortgages: A research-based explainer

A scourge of the housing market collapse before the Great Recession, adjustable-rate mortgages have made a comeback. What’s different now and what does the research say about these loans?

adjustable rate mortgage
(Avi Waxman / Unsplash)

About 60% of U.S. homeowners have a mortgage and most have a mortgage that lasts 30 years with a fixed interest rate. Monthly payments to the bank do not change over the life of those loans.

The U.S. is “the only country in the world in which the 30-year fixed rate residential mortgage is the dominant home mortgage product,” writes Lehigh University professor of finance Richard Kish in a February 2022 paper in the Journal of Real Estate Practice and Education.

Another type of home loan, called an adjustable-rate mortgage, is more common in other advanced economies, such as some European Union countries. These loans have also resurged in the U.S. as rates rise on 30-year fixed loans.

Compared with fixed-rate loans, adjustable loans often have lower rates to start, with rates subject to change in later years. For a homeowner these loans are a bet that their financial future will be bright, or that they will be able to sell before the adjustable-rate period kicks in. They are also attractive in certain economic environments, like the current one, with initial adjustable rates significantly lower than 30-year fixed rates.

Lenders offer adjustable-rate mortgages because they can potentially earn more interest for decades. For borrowers, if monthly payments rise and a homeowner can’t pay, that could mean less spending on other items or even foreclosure.

From early 2020 through early 2022, adjustable-rate loans made up less than 5% of all mortgage applications, according to the Mortgage Bankers Association, a nonprofit organization representing the U.S. mortgage finance industry.

But by mid-2022, they made up more than 10% of mortgage applications, a level unseen in over a decade. For the last full week of October, nearly 12% of mortgage applications were for adjustable-rate loans. The last time they were notably popular was during the run-up to the housing collapse that sparked the Great Recession of the late 2000s. Adjustable-rate mortgages made up over a third of mortgage applications each year from 2004 to 2007 before plummeting to less than 5% across parts of 2008 and 2009, and remaining under 10% until recently.

Given the uptick in adjustable-rate mortgages, and ongoing rate hikes from the U.S. Federal Reserve, it is important that journalists understand how they work and what the research says about them, including ways the mortgage market has become more heavily regulated since the late 2000s.

How do adjustable-rate mortgages work?

Homeowners with an adjustable-rate mortgage get a lower fixed rate, for a period of time, in exchange for a variable rate later on. The application process is similar for fixed-rate and adjustable mortgages, with lenders assessing applicants’ creditworthiness and ability to make payments.

The fixed-rate period for an adjustable-rate mortgage is usually five, seven or 10 years. One common adjustable-rate mortgage is called a 5/1. The five refers to the number of fixed-interest years; the one refers to how often the rate may change — once a year — after the fixed period expires. Other adjustable-rate mortgages, such as 7/1 and 10/1, follow the same pattern. For another type of adjustable-rate mortgage, called a 5/6, the fixed term is five years with the rate adjusting every six months.

Most adjustable-rate mortgages last 30 years, meaning for a 5/1 mortgage the borrower would have variable rates for 25 years. These borrowers might expect to earn enough by then to cover a monthly payment hike, or that they will be able to sell their home or refinance before the fixed term expires.

With average 30-year fixed rates historically low over the past three years — between 2.5% and 3.5% — the difference between those rates and adjustable rates was practically nil. Adjustable-rate applications were low because borrowers didn’t think it was worth the risk of potentially higher rates later for the benefit of shaving a tenth of a percentage point during the fixed term.

Today, the fixed period for an adjustable rate mortgage is one percentage point lower on average than a 30-year fixed-rate. An average 30-year fixed rate mortgage now comes with almost a 7% yearly interest rate. A 5/1 comes with 6% interest for the fixed term, according to a regularly conducted survey of lenders. A percentage point might mean hundreds of dollars of savings each month. This is the reason for renewed interest in adjustable-rate loans. Still, at 6%, the average rate for the fixed period of an adjustable loan is up about 3.5 percentage points from the start of 2022.

When choosing a mortgage, borrowers are making a decision that could have beneficial or disastrous consequences for their financial future. Research can help clarify how borrowers make those decisions. In a 2010 paper exploring the then-recent plunge in adjustable-rate mortgages, economists for the Federal Reserve Bank of New York note that in “the view of some analysts, households are largely myopic. They choose between adjustable-rate and fixed-rate mortgages simply by comparing the initial interest rates they would have to pay on the two contracts.”

After analyzing a large dataset of mortgage originations, the authors suggest that the mortgage decisions are not myopic but more closely linked to the difference between 30-year-fixed mortgage rates and recent average adjustable-mortgage rates. Put another way, borrowers don’t just look at the initial interest rates, they also consider what their adjustable rate might be longer-term.

Banks cannot raise interest rates as much as they want during adjustment periods. Maximum increases are spelled out in loan documents, so borrowers have a sense of how much they might be paying down the road. There are other safeguards, such as lifetime adjustment caps, which are usually 5%, and yearly increases, which are capped differently depending on the length of the fixed period.

Adjustable rates are based on the sum of two things: the index and the margin.

An index acts as a barometer of overall economic conditions. The index rate changes with market conditions. Different lenders tie these rates to different indexes. Changes to the index rate primarily affect how monthly payments change.

U.S. Treasury Department security yields are one common index. As the yield, or interest rate, rises or falls on Treasury securities — such as bonds — so goes the rate on an adjustable loan. Federal Reserve interest rates affect indexes, which is why when central bankers hike rates people with variable mortgages will probably see their monthly payments increase next time their payments are adjusted.

The margin refers to percentage points the lender adds in addition to the index rate. Margins vary by lender, but they hold steady during the life of the loan. The average margin has been around 2.75 percentage points on a 5/1 loan since 2005, which is as far back as the Federal Home Loan Mortgage Corporation has tracked that data.

Adjustable rates do not always increase. A borrower taking out a loan today could be betting that when it comes time for the fixed-rate period to end, index rates will be lower than they are now. In April 2010, 5/1 mortgages were about 1 percentage point lower than 30-year fixed mortgages. Five years later, with Federal Reserve rates hovering around 0%, those 5/1 mortgage holders would have seen their monthly payments fall. Given the Federal Reserve hikes over the past half-year, they will have seen monthly payments increase.

Are adjustable-rate mortgages risky?

News outlets often portray adjustable-rate mortgages as riskier than fixed-rate mortgages — and that is true by definition. It’s also worth noting in news stories that adjustable-rate mortgage holders are not locked in forever. Homeowners with an adjustable-rate mortgage can refinance, or switch, to a fixed-rate mortgage at any time if they qualify. The catch, as with any mortgage refinancing, is that the borrower has to pay closing costs, which can amount to thousands of dollars.

Also, adjustable-rate mortgages today are different from what they were during the Great Recession.

In 2006, during the lead-up to the housing market collapse that preceded that recession, some 90% of subprime mortgages featured an interest rate that was subject to change over the life of the loan, according to an August 2022 paper in the Journal of Risk and Financial Management. Subprime mortgages were mortgages lenders made to borrowers with low credit scores, who put down low down payments, had bankruptcies or other factors indicating they might be a risk to default.

Some adjustable-rate mortgages during the mid-2000s had shorter fixed-rate periods, meaning borrowers would face variable rates in 1 or 2 years, rather than five or more years. For some loans, borrowers only “needed only to show proof of money in their bank accounts,” while other lenders offered loans that “eliminated the need to prove or even to state any owned assets,” write the authors of the 2022 paper.

Before the Great Recession, adjustable-rate mortgage holders were “more likely to have been turned down for credit in the past five years, hardly ever pay off their credit card balances in full and utilize a higher share of credit card limits,” write the authors of a 2013 study in the journal Real Estate Economics. The authors of a U.S. Government Accountability Office report from 2010 find “loans that lacked full documentation of borrower income and assets were associated with increased default probabilities, and the influence of borrowers’ reported income varied with the level of documentation.”

More recent research also suggests higher adjustable interest rates historically track with more foreclosures. Arpit Gupta, a finance professor at New York University, analyzes foreclosures covering 40% of the mortgage market from 2000 to 2010 in a 2019 paper in The Journal of Finance. Gupta finds a “1 percentage point increase in [an] interest rate at the time of adjustable-rate mortgage reset results in a 2.5 percentage increase in the probability of foreclosure in the following year.”

Federal rules and legislation passed after the Great Recession make a housing market collapse less likely today. The Dodd-Frank Wall Street Reform and Consumer Protection Act, which became law in July 2010, is the most notable. It was written and shepherded by then-Senator Chris Dodd and then-Representative Barney Frank. The law introduced new oversight to nearly every corner of the financial industry.

Again, from the 2022 paper in the Journal of Risk and Financial Management:

“The Dodd-Frank Act, which is the most significant and comprehensive of all legislation, significantly lowers the risk on mortgage products by eliminating the no down payment loan option while tightening the underwriting criteria for mortgages based on the borrowers’ ability to pay; it also places various layers of legal responsibility on the lender, which includes comprehensive disclosure about the loan enabling the borrower to understand the major terms of the mortgage.”

The authors note that the Federal Reserve also requires banks to be better capitalized, in order to better withstand economic shocks. That means banks now have to have more cash on hand compared with their outstanding loans. Other federal disclosure requirements and notifications specific to adjustable-rate mortgages, like providing borrowers rate increase scenarios, have gone into effect in recent years.

Aside from the collapse of the U.S. housing market, current disclosure and reporting requirements exist for a reason: Research from 2008 in the Journal of Urban Economics found that “borrowers with adjustable-rate mortgages appear likely to underestimate or to not know how much their interest rates could change.”

Requirements on what lenders need to tell borrowers can change as political headwinds shift. Federal law from May 2018 rolled back parts of Dodd-Frank meant to protect minority mortgage applicants. In October 2022, a federal judge overturned a Trump-era Consumer Financial Protection Bureau rule exempting some small banks from reporting requirements aimed at ensuring equitable access to home loans.

Regulatory guardrails are designed to prevent a total housing market meltdown, but journalists should keep the recent spate of adjustable-rate mortgages in mind when covering the topic now and in a few years, when fixed-rate periods end.

Monthly mortgage payments that suddenly spike can affect communities by way of deferred home maintenance and lower property values. A study from 2016 in Urban Affairs Review examines residential property sales in Milwaukee from 2002 to 2013 and finds each tax delinquent property is associated with nearby home prices falling by more than $1,000.

Research to know

The COVID-19 Housing Boom: Is a 2007–2009-Type Crisis on the Horizon?
Diamando Afxentiou, Peter Harris and Paul Kutasovic. August 2022, Journal of Risk and Financial Management.

Household Mortgage Refinancing Decisions are Neighbor Influenced, Especially along Racial Lines
W. Ben McCartney and Avni Shah. March 2022, Journal of Urban Economics.

The Dominance of the U.S. 30-Year Fixed Rate Residential Mortgage
Richard Kish. February 2022, Journal of Real Estate Practice and Education.

Mortgage Refinance Costs and a Better Adjustable-Rate Mortgage Contract
Borys Grochulski. Federal Reserve Bank of Richmond, November 2021.

Forced moves and home maintenance: The amplifying effects of mortgage payment burden on underwater homeowners
John Harding, Jing Li, Stuart Rosenthal and Xirui Zhang. Real Estate Economics, August 2021.

Foreclosure Contagion and the Neighborhood Spillover Effects of Mortgage Defaults
Arpit Gupta. May 2019, The Journal of Finance.

Fixed-Rate Mortgages, Labor Markets, and Efficiency
Kangoh Lee. Journal of Money, Credit and Banking, August 2018.

What Calls to ARMs? International Evidence on Interest Rates and the Choice of Adjustable-Rate Mortgages
Cristian Badarinza, John Campbell and Tarun Ramadorai. Management Science, February 2017.

Assessing the Influence of Property Tax Delinquency and Foreclosures on Residential Property Sales
Deborah Carroll and Christopher Goodman. November 2016, Urban Affairs Review.

Why is the Market Share of Adjustable-Rate Mortgages So Low?
Emanuel Moench, James Vickery, and Diego Aragon. December 2010, Current Issues in Economics and Finance.

Do Borrowers Know Their Mortgage Terms?
Brian Bucks and Karen Pence. September 2008, Journal of Urban Economics.

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