Adjustable-rate mortgages (ARMs) became a dirty word after the collapse of the housing market and the ensuing onslaught of foreclosures several years ago. Buyers and banks got greedy. Borrowers were allowed to take out loans that were way too big for their incomes, but they were able to qualify because the initial teaser rate on ARMs allowed them to afford the first payments. Millions of Americans then lost their homes when their rates adjusted and they could no longer afford their mortgages.
Yet if dubious ARM loans may have been a part of the problem, they may also have eased the blow to the housing market after the bubble burst, according to a new paper. In their study, Andreas Fuster and Paul S. Willen found that during the housing crisis, borrowers with ARMs saw their monthly mortgage payments drop on average by roughly half as the economy tanked pulling interest rates down with it. They studied a sample of hybrid adjustable rate mortgage that had seen substantial rate reductions over the past five years or so and reported that “interest rate reductions dramatically affect repayment behavior, even for borrowers who are significantly underwater on their mortgages.” They estimated that ”cutting a borrower’s payment in half reduces his hazard of becoming delinquent by about 55 percent, an effect approximately equivalent to lowering the borrower’s combined loan-to-value ratio from 145 to 95 (holding the payment fixed.)”
So even though many defaulted because they could no longer afford their ARM loans, many also were able to keep their homes because their ARM rates adjusted to such low levels during the Great Recession that their payments stayed low. If they had had fixed rate mortgages, the economic downturn may have landed many more homeowners in foreclosure.
A counter argument could be made, however, that without ARM loans many of those borrowers would not have qualified for a home loan in the first place and the foreclosure crisis may never have happened. Risky, reckless lending and borrowering are generally cited as major cause for the housing trouble.
Fuster and Willen’s work is also startling though because previous studies had shown that having significant negative equity was a major cause of strategic default even when borrowers could afford to keep making their payments. This new paper says the size of the payment may be the most important factor. That would be welcome news to the Obama adminstration who has been diligently pushing its Home Affordable Refinance Program. The initiative helps struggling homeowners refinance into loans with much lower interest rates and payments. While it has had a somewhat high redefault rate, the program has prevented hundreds of thousands of borrowers from going into foreclosure.