Who knows where the adjustable rate mortgage (ARM) come from?

There was enormous inflation in the 1970’s. At that time, mortgages were most commonly 30 year fixed, giving a borrower a rate that was locked in for a long time. The borrowers knew what the housing cost would be and the lenders knew what the return was. Due to inflation, there was a demand for a higher return and the lenders had to increase the interest paid out to depositors to much higher levels than the return on their current mortgages. The banks needed to offer customers (depositors) a higher return in order to attract deposits. In turn, the interest rates increased steadily for fixed rate mortgages.

The ARM was presented, first, by banks in California and then became widespread as a normal loan product throughout the country. During this inflationary period, interest rates on fixed mortgages were sky rocketing. So, the banks offered a lower interest rate for a shorter term mortgage, hence the ARM. After a designated period, the interest rate would adjust. This way the banks would hedge against inflation, while offering the consumer a lower interest rate. The consumer, however, bore a great amount of risk with these loans. As inflation and interest rates increased, the borrowers’ rates would go up according to the adjustment outlined in the terms of the mortgage.

In the past ten years, the ARM was quite popular because the interest rates offered were lower than fixed rates, by at least a half of percent or more. As the short term bank lending dried up, short term mortgage rates increased, making them equal or higher than fixed rate loans at this writing. Since interest rates are still low for fixed mortgages, this is not a problem. Nevertheless, when interest rates rise on the 30 yr and 15 yr fixed loans, short term (ARM) rates would hope to remain lower. If short term bank lending is still a problem than the short term rates should also increase, providing no reprieve to borrowers.

 What then, will Arnold do for California and the rest of us?

 Dale Siegel