Adjustable Rate Mortgages and the Housing Bubble

Why do people take out an adjustable rate mortgage (ARM) when buying or refinancing a house? Many economists would probably argue that it should depend primarily on one’s expectations for future interest rates: if you think interest rates are very low and are likely to rise, you should lock them in with a fixed rate, while if you think they are likely to fall in the future then an ARM makes more sense.

But there is another possible reason that people may prefer an ARM, in a world where people are credit-constrained: ARMs charge a lower rate of interest, at least initially, and thus enable one to pay more money for a house for a given a monthly mortgage payment.

With this in mind, take a look at the following chart. The dark and light blue lines show the average interest rate charged on 30-year fixed and 1-year adjustable rate (AR) mortgages since January 2002. Meanwhile, the orange line (measured against the right axis) shows the percent of new mortgages taken out that have an adjustable rate.

Source: Mortgage Bankers Association data on new mortgage applications. Data represents the average of the second and third weeks of each month.

Clearly the proportion of ARMs jumped in the summer of 2003, and again the spring of 2004, in response to jumps in fixed interest rates. But the odd thing is that after both jumps in the 30-year fixed interest rate, it then subsquently fell, nearly back to where it started. Yet the proportion of borrowers choosing ARMs over fixed rate mortgages did not fall. The result is that, even though the interest rate on ARMs is about the same as it was in the second half of 2002, and the interest rate on 30 year fixed mortgages is lower than it was then, a far larger portion of mortgages today are ARMs.

In other words, it seems that there has been a secular underlying trend toward ARMs. Now we come back to my opening comments in this post. I would suggest two possible reasons for this trend toward ARMs and away from fixed-rate mortgages: either expectations about future interest rates have changed, or increasing numbers of people have decided to pay more for their house than they can afford with a fixed-rate mortgage.

Personally, I don’t really believe that interest rate expectations have changed that dramatically since early 2003. (Reasonable people could differ on this point, however.) So to me, the orange line in the chart above tells the story of millions of home buyers who are spending more than they could afford at an interest rate of 5.5-6.0%. After all, if they could afford their house at 5.5%, and if they don’t expect interest rates to fall dramatically, then they would have chosen the fixed rate mortgage, not the AR mortgage.

This is bad news, because an interest rate of 5.5-6.0% is not that high… and yet it’s too high for many recent home buyers. If 1-year interest rates to rise by just 1.5%, millions of recent home buyers will find their mortgage payments unaffordable. Yet there are plenty of reasonable scenarios that raise 1-year interest rates by that modest amount in the next year or two… which means that we shouldn’t find it surprising if millions of recent home buyers soon find themselves unable to afford to live in their own houses.

Kash