Are Risky Mortgages Making a Comeback? Here’s What We All Must Know.

Adjustable-rate mortgages (ARMs) can be helpful financial tools. They can also create trouble when the rate adjusts upward.

Since the pandemic, adjustable-rate mortgage loans have seen a comeback. And some market watchers are becoming concerned. As one headline put the point this month: Adjustable-Rate Mortgages Caused Trouble in 2008. They’re Worrying Experts Again.

How an Adjustable Rate Mortgage Loan Works

An ARM is typically chosen in times of elevated interest rates. It works like this.

The initial monthly interest is fixed for a period of (typically) five to ten years. In contrast to the more common 30-year, fixed-rate mortgage, an ARM’s rate will change after its initial period. It’ll either rise or drop down, depending on the market’s prevailing interest rates.

To start, the ARM tends to have a lower initial rate than the 30-year fixed. So, borrowers who expect their incomes to rise later, but want to acquire a deed now, may opt for the ARM. These borrowers might figure they can afford a higher rate later, or they’ll be in the position to refinance in a few years.

Yes, those attractively low opening rates can and will change. A sharp increase in interest can catch a deed holder off guard.

ARM loans were common in the rash of foreclosures that badly wounded the U.S. housing market in 2008. The Federal Reserve found that most loans extended to borrowers with poor credit (subprime mortgages) had adjustable rates. Borrowers whose finances couldn’t support rate hikes went into default.

This is the risk that the ARM presents. A borrower in distress may or may not be able to refinance and pay the closing fees.

Risk Dynamics: From 2000 to Now 

The economic slowdown following the pandemic of 2020 pushed mortgage rates down. Many people at that point applied for mortgages. Some were first-time home buyers. And some wanted to relocate for work or go remote.

By 2021, the prevailing interest rates had dropped to bargain-basement levels. Unlike at the start of the 2008-09 financial crisis, most 2021 borrowers opted for fixed-rate mortgages. And that’s good for those borrowers. Their rates have not shot up. Their fixed-rate loans have preserved those sub-4% interest levels from 2021.

Anyone who did get an ARM at that time, of course, has seen their rates rise dramatically. If they signed up for an initial five-year rate, they’ve received lender notices that their rates are about to change. Fortunately, today’s ARM holders are not numerous enough to unsettle the U.S. housing market.

The stronger concern today is inflation, and potential weakening in the country’s job market. People getting risky mortgages now, when borrowing is harder, could bring new risks into the housing market.

Piggy-Back Loans Resurface, Alarming Deed Holders

Some deed holders who try to refinance their homes after financial setbacks years ago are now coming face to face with unpleasant surprises. Second-mortgage liens they’d presumed were discharged in the wake of the mortgage crisis have come back to haunt them.

“Zombie mortgages” are forgotten home loans that arise from the past, when the owner wants to refinance or transfer the deed. They’re usually second mortgages, dating before the foreclosure crisis. By the time they resurface, they’ve ballooned on account of years of unpaid interest charges.

Before the 2008 crash, borrowers would take out those piggy-back mortgages to cover down payments. This way, the borrowers could avoid the burden of mortgage insurance. Lenders issued millions of piggy-back loans in the years leading up to 2008. Bank of America, Wells Fargo, Citigroup, JPMorgan Chase and Wells Fargo held $400+ billion in piggy-back mortgage liens as of late 2009.

The extra financing made homes easy to get. But when interest rates went up, so did defaults on these precarious home purchases.

To avert foreclosure, a deed holder would request loan modifications. Some believed their loans were forgiven or discharged in bankruptcy.

Oftentimes, the banks would not bother the borrowers if the loans weren’t worth collecting. Banks might have deemed a given loan “charged off” or “written off.” Legally speaking, that did not let the borrower out of their contractual agreements to resolve these liens. 

It seems unfair, and to some extent it was. The banks were receiving bailouts; what about the deed holders?

And how was a deed holder supposed to know that an old lien still existed?

If it was actually forgiven, a deed holder would receive an IRS 1099-C form in the mail. This form would be filed with their tax returns for the year of cancellation. The deed holders might also have found the old liens by checking county deed records or ordering a title search. But how many thought to do so? Especially if they had reason to believe the loans were dead? But some weren’t dead. These were sold to investors who sat on them until home values rebounded and the debts became worth collecting. Hundreds of thousands of these loans were left on the books, and many are still unresolved. (These zombie liens are able to survive Chapter 7 bankruptcy cases.)

Will History Repeat Itself?

It’s not 2008. And yet, people are definitely using second mortgages to acquire deeds. By 2024, mortgage rates were up again, and so were second mortgages—especially with Federal Housing Administration (FHA) loan borrowers with modest incomes, and first-time homebuyers who have no built-up equity to use. In just two years, the number of FHA mortgages that had piggy-back loans on them was up from about 11% to a whopping 18%. This is according to a CoreLogic study discussed by National Mortgage Professional.

To a lesser extent, the dynamic of financing to the hilt is also occurring with conventional loan borrowers..

Will these deed holders be resilient? Time will tell. Much depends on the overall economy. And much depends on what kind of circumstances befall these deed holders while they try to build strength through home equity.

Where you go for a second lien matters. Some second mortgages charge balloon payments when the homeowner transfers the deed or seeks refinancing. But there are safe down payment assistance plans that allow for mortgage forgiveness and charge zero in interest. Ohio offers an exemplary plan.

Important note: This article provides information only. It is not to be relied on as legal or financial advice. To preserve your rights, it may be wise to call an attorney before responding to a zombie mortgage debt collector.