Final answer:
Fixed rate mortgages maintain a consistent interest rate, ensuring constant monthly payments. In contrast, adjustable-rate mortgages adjust with market interest rates and inflation, meaning that if inflation falls by 3%, homeowners with an ARM would likely see decreased interest rates and monthly payments.
Step-by-step explanation:
Fixed rate mortgages are characterized by having the same interest rate throughout the entire duration of the loan. Whether the mortgage term is for 15 or 30 years, the rate remains unchanged, providing predictability in monthly payments for homeowners. On the other hand, an adjustable-rate mortgage (ARM) fluctuates with market interest rates, and typically, the initial rate is lower than that of a fixed-rate loan as compensation for borrowers taking on inflation risk. If inflation unexpectedly falls, as in the scenario where it drops by 3%, the interest rate on an ARM would likely decrease. This is because ARMs often include inflation adjustments, and a drop in inflation could result in a reduction in interest rates, subsequently leading to lower monthly payments for the homeowner with an ARM.
Consider the example provided: when ARMs adjusted from a low introductory rate to a higher rate, homeowners experienced significant increases in their monthly interest payments. This exemplifies the risk involved with ARMs compared to the stability of fixed-rate mortgages. Banks who purchased these loans, assuming property values would remain stable or increase, faced financial losses when homeowners defaulted on devalued properties.