As your textbook indicates, a variety of new mortgages were developed and approv

Question

As your textbook indicates, a variety of new mortgages were developed and approved by regulatory authorities after serious problems for holders of fixed-rate mortgages in the early 1980s. Adjustable rate mortgages (ARM) were part of those innovations approved.

Please, discuss the following inducing questions:

1) What is an adjustable rate mortgage (ARM) and how it differs from conventional mortgages in contractual terms?

2) How adjustable rate mortgages (ARM) have been associated with the recent real estate crisis?

Explanation / Answer

An ARM resets its interest rate periodically throughout the life of the loan: a conventional has one rate that does not change. ARM's were associated with the real estate crisis because they would reset to a level that the owner of the property could not afford. He would then try to sell the property and would often find he was "underwater", that the market price of the home had dropped to the point where the proceeds would not pay off the mortgage. He would then walk away from the property and the mortgage, leaving the financial institution stuck with the property and the loss. The property would be put on the market, adding to the glut of homes and further driving down prices, exacerbating the situation.

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