A Yale economist says a risky type of mortgage that contributed to the 2008 crash could save you money in the long run — if you can stomach uncertainty

• Most Americans have a fixed rate mortgage, meaning their interest rate stays steady over time.
• A Yale economist says adjustable rate mortgages can help borrowers save money on interest in the long run.

As interest rates soar, Yale economist James Choi is touting a type of mortgage that helped contribute to the housing crash of 2008.

On a recent Freakonomics Radio podcast, Choi said borrowers looking to save money may want to forsake the mortgage industry's darling, the 30-year fixed-rate mortgage, for the less popular alternative: an adjustable-rate mortgage.

That's because his research found that adjustable rate mortgages "tend to on average have lower interest rates than fixed rate mortgages," Choi said, pointing to his September paper for the National Bureau of Economic Research. Given interest rates are on the rise, his argument suggests that particularly now, adjustable rates provide borrowers the best chance at minimizing their interest payments over the long run.

Adjustable-rate mortgages, also known as ARMs, are home loans with an interest rate that adjusts over time depending on the fluctuation of market rates. They're less predictable than fixed-mortgages, but are attractive due to their potential to take advantage of times when interest rates are low.

A home buyer who took out an ARM last October, for instance, would initially have an interest rate of 2.56%, but in October of this year, that rate would have climbed to 5.96%.

Some personal finance experts have argued the unpredictability of payments makes ARMs too risky.

Radio host, author, and financial personality Dave Ramsey has long espoused the opposite of Choi's advice. "Your interest rate is adjustable and you'll have zero control over it," said Ramsey. "When you get an ARM, you're playing with fire — why take the risk?"

But Choi disagrees. While borrowers with fixed rates can refinance when rates fall, Choi's paper cited a study that found many borrowers "fail to refinance optimally" and therefore would still have been better off with an ARM, as it automatically adjusts to interest rate changes.

Another option is to opt for a hybrid mortgage, which includes a fixed payment for say, five years, before shifting to a floating rate. But Choi's research suggests that again, these borrowers would have been better served with an adjustable rate.

"For most people, the adjustable rate mortgage is preferable unless the fixed rate mortgage rate is at a historic low or if you're really stretching your budget to buy your home," Choi said. Interest rates were near historic lows over the last few years, but that time has passed, and they are now at a 20-year high.

More borrowers seem to be buying in.

As the Federal Reserve continues its aggressive fight against surging inflation, Americans face rates that have nearly doubled in the past year. Affordability has become a top concern for many prospective buyers, and it's causing more of them to opt in for ARMs. According to the Mortgage Bankers Association, applications for ARMs reached a fourteen-year high in May — and are expected to continue climbing. In June, the MBA's chief economist said roughly 10 percent of mortgage applications were for ARMs, up from 4% in 2021.

"More borrowers continue to utilize ARMs to combat higher rates," Joel Kan, the MBA's associate vice president of economic and industry forecasting, said in a statement.

ARMs played a role in the 2008 housing crash — but things have changed

While adjustable rate mortgages may raise alarms for those who recall their role in the 2008 housing crisis, Jude Landis, vice president of single-family risk management at Fannie Mae, says their resurgence is not cause for concern.

"The mortgage market has shifted dramatically since 2008," Landis said in a statement. "Improvements in underwriting, technology, and quality controls – some visible, some less so – have resulted in a fundamentally sounder mortgage system than before the crisis of 2008."

"Lenders have strengthened their mortgage origination processes, including improved underwriting and collateral assessment," Landis said. "Additionally, appropriate regulations, such as the ability-to-repay and qualified mortgage rules, have formed guardrails for mortgage lending standards that did not exist 10 years ago."

But although the product has become a less risky bet, Choi acknowledges that they remain unpopular among many personal finance experts.

In his September paper, which compared the advice in popular personal finance books with that of economists, Choi analyzed 24 books that discussed mortgage decisions and found that not a single one advised getting a traditional ARM.

On the Freakonomics podcast, he speculated that this is because "academic literature on optimal mortgage choice is not very well known." His paper cited three studies published in the Journal of Finance and the Quarterly Journal of Economics that point to the benefits of adjustable rate mortgages.

Ultimately, even if the long-term odds are in the borrower's favor, an adjustable rate mortgage carries its risks. If rates remain higher than usual over the course of the loan repayment, a homeowner could end up paying more than they would have with a fixed rate mortgage. In the short run, borrowers without sufficient financial cushion may struggle to get by during higher interest rate periods.

For many fixed-rate homeowners, the peace of mind that comes with having their monthly payment set in stone may be worth the chance they pay some additional interest over the long run.

As Ramsey suggested, they might favor certainty over "playing with fire."