The interest-only, adjustable-rate mortgage (IO ARM) became popular early in the Great Housing Bubble. When fixed-rate mortgage payments were too large for buyers to afford, they turned to IO ARMs as an affordability product. Unfortunately, these mortgage products are not stable because at some point, payments increase, and the borrowers often default.



A fixed-rate conventionally-amortized mortgage requires the borrower to repay part of the mortgage balance with each payment. If this repayment requirement is eliminated, which it is with an interest-only, adjustable-rate mortgage, then the borrower can finance a larger sum and bid more for residential real estate. These loans helped inflate the Great Housing Bubble.

In the California coastal bubble of the late 80s, interest-only, adjustable-rate mortgages did not become common, and that bubble did not inflate far beyond people ability to make fixed-rate conventional mortgage payments. This is also why prices were slow to correct in the deflation of the early 90s. Most sellers did not need to sell, so they just waited out the market. The correction was a market characterized by large inventories, but this inventory was not composed of calamitous numbers of must-sell homes. The few must-sell homes that came on the market in the early 90s drove prices lower, but not catastrophically because the rally in prices did not get too far out of control. The Great Housing Bubble was different.

IO ARMs are risky because they increase the likelihood of borrowers losing their homes. IO ARMs generally have a fixed payment for a short period followed by a rate and payment adjustment. This adjustment is almost always higher; sometimes, it is much higher. At the time of reset, if the borrower is unable to make the new payment (salary does not increase), or if the borrower is unable refinance the loan (home declines in value below the loan amount), the borrower will lose the home. It is that simple.

These risks are real, as many homeowners have already discovered. People try to minimize this risk by extending the time to reset to 7 or even 10 years, but the risk is still present. If a house were purchased in California in 1989 with 100% financing with a 10-year, interest-only loan, at the time of refinance the house would have worth less than the borrower paid, and they would not have been given a new loan. (Fortunately 100% financing was unheard of in the late 80s). Even a 10 year term is not long enough if purchased at the wrong time. As the term of fixed payments gets shorter, the risk of losing the home becomes even greater.

People who used interest-only, adjustable-rate mortgages during the Great Housing Bubble will likely lose their homes in foreclosure. Prices will not recover soon after they bottom as the overhang of inventory and the tightening of mortgage loan terms will stifle appreciation for years to come. Whatever the length of the initial fixed term, it will not be long enough for prices to recover. The government may step in and refinance these people anyway, but absent a government program, these mortgage holders will not be able to refinance, and many will face foreclosure.