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Adjustable Rate Mortgages?

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Unlike a traditional fixed-rate mortgage, an ARM's rate adjusts periodically, based on an index of some sort.

So you know how they work?


But do you know why they exist?


Back in the late 1970's and early 1980s some interesting things were happening in the world of banking. Lenders had written thousands of fixed-rate mortgages at 7-8-9 percent fixed rates, contracts with the home buyer that essentially tied up the lender's money for 15-30 years.

The practice of bundling mortgages into securities and selling them on the secondary market wasn't yet widespread, (although S&L's had begun to do so some years earlier)

if banks wanted to loan out more money- they largely had to bring more money in through the front door.


Meanwhile- interest rates began to rise...and rise.....and rise... from 7-8-9 percent up to 10-12-14 and briefly even higher.

Banks - needing to attract and retain depositors- had to correspondingly increase interest rates paid on savings vehicles. Deposits are generally short-term and easily withdrawn ..Sure... a toaster with your new account was nice...but what are your rates?


The bank that fell behind risked losing depositors to the better-paying bank across town, an event that could cause a death spiral once they hit their minimum reserves.

A lender that couldn't write loans was a lender dead in the water.

This problem was close enough to reality for the Fed's to rewrite the rules; reducing net worth requirements to as low as 3% and allowing certain lenders to use multi-year averages to calculate their reserves!

Lenders began scratching their heads, they were sitting in a precarious position.


The 1970's and early '80s were years of inflation and a sluggish economy, the Fed Reserve began to take a much more active role in managing the nation's monetary supply. This meant banks could no longer count on interest rates remaining relatively stable- they could and would change.

Paying double-digit interest on deposits while holding long-term loans at much lower rates?

Well- this was no way to make money!

Then the brainstorm hit.

Why not transfer that risk away from the bank and over to the borrower?

Adjustable rate mortgages- ARM's do exactly that! When rates go up- the bank isn't left holding the bag, they can adjust the rate on the money they have loaned out!



The concept of the ARM dates back to 1959 when a former Wisconsin Assemblyman named William Double (Note: there is no irony like unintentional irony. "Will Double" couldn't be a more appropriate name)

devised a plan to allow mortgage rates to adjust periodically. The idea found some initial popularity in California, but remained largely unused until the Savings and Loan industry began offering them as a mainstream product.


Problem was those pesky consumers.

They weren't thrilled over what the bankers had planned for them, knowing if their banker was smiling -they probably should not be-

and the early ARM's were overwhelmingly ...unpopular. There were better options.


The answer? Find someone who doesn't have better options!

There was a largely untapped goldmine of consumers wanting to own a home but suffering from marginal credit....others who couldn't afford what they truly wanted to buy- both locked out of the mortgage market.


........... Until now.

Lenders began marketing ARM's to "subprime" borrowers and those wanting to buy "a little more house" , often coupled with a hefty prepayment penalty to keep them locked in....and those borrowers responded by forming lines to sign on the dotted line.


New lenders sprang up offering nothing but 2/28 ARM's with relatively low initial rates, followed by a whopper of an adjustment.

Oh, and that 2-year prepay penalty to keep you around for when the fun started ;) -that sweetie came as standard equipment. You'll love it! Now just sign here!

Remember the TV ads: When others say no, XXXXX says YES? Yes! Yes! Yes!


ARM's did gain some respectability in later years as a tool for people in certain situations, largely as a result of marketing efforts by certain prime lenders; but for the most part- they were a staple of the subprime and bloated purchase industry.


Thrilled with their newfound revenues, lenders came up with an entirely new way to double their profits- the 2-year refinance- complete with a new set of fees!

Lessee...how can we sell that?

Take the ARM's intro rate for 2 years and save save save! Put that money into an investment (absolutely nobody did) and in 2 years- refinance!

Like selling freezers to the eskimos, they'd found a way to sell another mortgage to someone that already had one!

Bless their hearts- Gotta love 'em.

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