Americans Turn To Riskier Mortgages As Borrowing Costs Explode. Sound Familiar?

Americans are increasingly turning to adjustable-rate mortgages to escape borrowing costs above 7%, reviving a type of home loan that played a prominent role in the housing collapse preceding the 2007-2009 financial crisis.

Adjustable-rate mortgages, or ARMs, accounted for 9.8% of mortgage applications during the week ending Sept. 18 as the average 30-year fixed mortgage rate surged to 7.12%, its highest level since May 2024, according to the Mortgage Bankers Association. The shift was notable because borrowers were accepting the risk of future rate increases for relatively modest savings compared with a traditional fixed-rate mortgage.

Rates illustrated the tradeoff. The average 30-year fixed mortgage stood at roughly 7.22% Monday, compared with about 6.52% for a five-year adjustable-rate mortgage, according to Bankrate, a difference of roughly seven-tenths of a percentage point.

The Mortgage Bankers Association similarly found borrowers increasingly choosing ARMs as fixed rates climbed, with Chief Economist Mike Fratantoni saying borrowers were seeking adjustable loans because rates on five-year ARMs were more than one percentage point below fixed mortgages.

Adjustable-rate mortgages typically carry a fixed introductory rate before resetting based on prevailing interest-rate benchmarks, meaning borrowers can face higher monthly payments when rates rise.

Adjustable-rate mortgages, particularly loans made to subprime borrowers under weaker lending standards, were at the center of mounting mortgage distress before the financial crisis. In 2007, serious delinquency rates on subprime adjustable-rate mortgages climbed to nearly 16%, according to the Federal Reserve, as borrowers struggled with deteriorating housing prices and approaching interest-rate resets.

The subsequent losses spread well beyond homeowners. Mortgages were bundled into mortgage-backed securities and other structured products held across the financial system, and mounting defaults caused investors to question the value of those securities. The Federal Reserve later said deterioration in subprime mortgages, particularly adjustable-rate loans, helped expose weaknesses throughout financial markets.

Today’s mortgage market differs from the one preceding the financial crisis, particularly because lending standards have tightened and the current increase in ARMs was not concentrated in the same kinds of poorly underwritten subprime loans.

Still, borrowers choosing an ARM are making a similar fundamental trade: accepting uncertainty about future payments in exchange for a lower mortgage rate today.

That trade was becoming more attractive as housing affordability deteriorated.

With a 30-year fixed rate above 7%, even a reduction of less than one percentage point can translate into meaningful monthly savings on a large mortgage. But when an ARM’s introductory period ends, its interest rate can reset higher depending on the underlying benchmark, potentially raising the borrower’s monthly payment.

The Federal Reserve’s Sept. 16 rate hike adds to that risk. The central bank raised its benchmark rate by a quarter point to 3.75% to 4%, while other short-term borrowing benchmarks moved higher afterward.

Rising yields on Ten-year Treasurys, which influence mortgage costs, could also endanger ARM borrowers if yields remain elevated. Ten-year Treasury yields hit a high not reached since the financial crisis in mid-2007 on Monday.

Americans are also carrying hundreds of billions of dollars in another major form of variable-rate housing debt.

Home equity lines of credit, or HELOCs, generally carry variable rates that can rise alongside broader interest rates. Americans held $459 billion in outstanding HELOC balances at the end of the second quarter, according to the Federal Reserve Bank of New York, up $142 billion from their 2022 low.