Adjustable-Rate Mortgages

Since the early 1930s, the standard residential mortgage instrument used in the United States has been a fixed-rate mortgage (FRM). Although it was not often called an FRM, this instrument had a fixed interest rate, which was established at the beginning of the loan period; a constant or level payment or debt service, consisting of both interest and principal; and a fully amortizing repayment schedule, which included a sinking fund payment. At the conclusion of the repayment schedule, the entire principal is systematically repaid to the lending institution with level payments throughout and at the constant interest rate stated on the loan.

During periods of anticipated inflation, however, it is cumbersome to use the FRM as a viable mortgage instrument. This is due to the tilt effect. This phenomenon refers to the fact that the actual (real) burden of the loan increases dramatically at the beginning of the life of the loan when inflation is anticipated. In effect, the borrower is asked to pay a mortgage interest rate that reflects inflationary expectations for the entire life of the loan, yet the borrower's income is lower than is expected in future years. During periods of high interest rates in the 1960s and 1970s, it became clear that the FRM was deficient as the primary mortgage instrument in the U.S. financial system.

In 1978, a state-chartered California savings and loan association introduced what was initially called a variable-rate mortgage (VRM) as an alternative to the FRM. The VRM became the predecessor of the adjustable-rate mortgage (ARM) in 1982, when the Federal Home Loan Bank Board adopted the ARM as its alternative mortgage instrument of choice. In the years that followed, numerous variations were created, and several ARMs were used in practice throughout the United States.

Both the original VRM and the ARM were aimed at alleviating the burden of the tilt effect for household borrowers. In addition, the availability of the ARM enabled financial institutions to offer mortgages without pricing interest rate risk far out into the future. This instrument also enabled financial institutions to solve the “mismatching” problem common during periods of rising interest rates: borrowing in the short-term market at relatively high interest rates and lending to borrowers in the long-term market at relatively low interest rates.

Because the ARM, unlike the FRM, did not require lenders to estimate the effects of interest rate changes, lenders could offer ARMs at lower interest rates. This is because borrowers bear the risk associated with future interest rate changes when an ARM is used. Conversely, borrowers pay a premium for the option to avoid future interest rate rises when electing an FRM.

ARMs require the specification of some additional parameters, including interest rate floors, ceilings (called “caps,” limiting both the total adjustment allowable over the life of the loan and the maximum adjustment per period), and a specified index and formula for adjusting future mortgage rates to be applied to the remaining balance of the loan. Over time, these parameters have become standard with market experience. For example, [Page 12]many mortgages allow rates to fall or rise but not more than about five percentage points (500 basis points) over the life of the loan. Frequently, ARMs are also limited to adjusting 150 to 200 basis points during any one year. The 1-year Treasury bill average serves as a common index in many residential mortgage markets. During the past decades, many variations were tried. Successful instruments remain in force, and others were discontinued. No doubt, ARMs are more complicated than FRMs but continue to serve as useful alternatives in most U.S. mortgage markets.

...