There were a lot factors that contributed to the financial crash, and there’s even more debate about exactly what caused what. The goal here isn’t to determine once and for all what caused the crisis, but to shed some light on one part of the crisis that’s often misunderstood.
Obviously, there was a great deal of frustration that came out of the crash, and one of the unfortunate byproducts of that frustration is that a number of different products and processes were caught in the crossfire, including the adjustable rate mortgage (ARM).
Although ARMs were one type of loan used prior to the crash, what was called an ARM then and what is an ARM now are very different.
How ARMs Used to Work
An ARM is a mortgage that usually lasts for 30 years, but for the first few years – exactly how many depends on the specific loan – the interest rate is fixed. Once that period is up, the rate can adjust up or down as the market changes.
In a Markets and Musings video, Quicken Loans Chief Economist Bob Walters goes in-depth with ARMs, explaining that an adjustable rate mortgage is just a basic structure – with the rate being fixed for a certain amount of time and then periodically adjusting after that – and what’s important is how you build on that structure.
Prior to the crash, some ARMs had shorter fixed-rate periods, higher lifetime caps or were given with no money down or just stated income. An ARM with a high lifetime cap means that the interest rate could adjust to a very high payment if the market continued to increase. Many times, clients who obtained loans with no money down or just based on their stated income as opposed to their actual, verified income would have a much more difficult time paying back the loan because they really weren’t able to afford it to begin with.
You see, it’s not the fact that the rate changed, but when and how it changed that caused people to lose their homes. Many people agreed to ARMs not fully understanding the implications of their loan agreement, and some probably just hoped they’d have more money by the time their mortgage adjusted to a higher payment – never something you want to do.
How ARMs Work Now
Current ARMs are quite different from their pre-crash stepsiblings. ARMs are now better regulated by the government, and always have periodic and lifetime caps so that your rate can only adjust a certain amount each year and over the life of the loan – usually not more than 5%. With Quicken Loans, you can get 5-, 7- and 10-year ARMs with several different adjustment plans depending on the specific loan.
Why Many People Use ARMs
ARMs are a much better choice than a fixed-rate mortgage for those who don’t plan on staying in their home for 30 years because initial ARM rates (the rate you’d pay on your mortgage for the first 5, 7, or 10 years) are lower than the rate of a fixed-rate mortgage. What this means is that if you get a 10-year ARM and move into a new home in less than 10 years, you paid a significantly lower rate during the time you were in that home than if you had gone with a 30-year fixed-rate mortgage, for example.
As you can see, while subprime ARMs were a factor in the crash, they weren’t the cause of it, and, more importantly, ARMs are a great way to save money and build a stronger financial future for yourself.
If you still have some questions about ARMs, ask us in the comments below!