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Oct 03

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Proceed with caution — adjustable rate mortgages gain new life

Mortgage rates are low. Absurdly low. They are lower today than at any time during the 1970’s, 1980’s, and 1990’s. In fact, they’re lower today than they were at any time during the huge run up in housing prices — fueled by historically low mortgage rates — that ended in 2006. Today many borrowers are landing 30-year fixed rate mortgages at rates of less than 4%. That’s barely above historical rates of inflation, which, for the past thirty years have averaged around 3%. This is an ideal time to lock in an extremely low rate.

Yet, according to a report by SmartMoney, adjustable rate mortgages (ARM) are making a comeback. The report observes:

For the first six months of this year, ARMs accounted for 13.4% of the total mortgage market, according to the latest data available from Inside Mortgage Finance, a trade publication. That’s up from 9.5% for all of 2010 and 6.3% in 2009.

How is this possible? When rates are this low, and the housing market’s stability remains questionable, why would anyone opt for an adjustable rate? Opting for an ARM at this time is a short-sighted move that is likely to hurt borrowers.

The upside of an ARM is that the initial rate is lower than that of a fixed rate mortgage. A report by the Wall Street Journal indicates that while 30-year fixed rates recently average 4.01%, five-year Treasury-indexed hybrid adjustable-rate mortgages were averaging 3.02%. At these rates, the borrower who opts for the 30-year fixed mortgage over the 5-year ARM makes a mortgage payment of $1,434, assuming a $300,000 balance. The 5-year arm would cost $166 less per month, just over a 10% discount (this ignores that, in reality, the savings would actually be somewhat less since interest is tax deductible). So, yes, the ARM offers some savings and, of course, this is why borrowers opt for it.

The downside of an ARM, of course, is that the rate can go up — as much as five percent. Given their record lows, it is almost certain that they will go up. Supposing that an ARM’s rate does increase 5%, the initial $166 monthly savings (using our example above) turns into a monthly loss of $770 relative to a 30-year fixed mortgage on the same loan.

Banks are taking new measures to assure that these loans are less risky — for the bank. But the borrower’s risks are as great as ever. Requiring a solid credit score, substantial down payments, and proof of income helps protect the bank against risk of borrower default. But buyers are still exposed the risk of a higher rate. In fact, the measures taken by banks actually make ARMs less attractive to borrowers since borrowers stand to lose more (i.e. their down payment) in the event of foreclosure.

The reasoning behind an ARM made a lot more sense for borrowers several years ago. Foremost, the housing market was on a tear. Housing prices were growing at double digits year over year and borrowers reasoned that if rates reached the point that they could no longer make their monthly payment, they would simply sell at a substantial profit. Few people considered the possibility that housing prices could actually fall — an easy assumption to make give all the folklore of the time about how a drop in housing prices would never occur. But they reasoned, in the super unlikely event that housing prices did fall, the worst that could happen is that they walk away at minimal financial loss since banks didn’t require them to put any money down.

All that reasoning fails today. Substantial down payments won’t allow borrowers to walk away with minimal financial loss. Nobody expects to turn around and sell their property at a substantial gain in a few years — unless they purchased the property at a substantial discount to market rates. The only benefit to borrowers today is an initially lower rate, but not that much lower. Borrowers should think twice, and then think again, before they opt for these illusory savings.

About the author

Eric Madsen

Mr. Madsen is a Chartered Financial Analyst (CFA) charterholder and a Manager at Fulcrum Inquiry, a finance and economics consulting firm that performs economic damages analysis involving commercial litigation, financial investigations, business valuations, and forensic accounting. He also holds an MBA from the UCLA Anderson School of Management and a B.S. in Economics. He conducts expert analysis in finance and economics. Mr. Madsen may be contacted at 213.787.4122 or at emadsen@fulcrum.com.

Permanent link to this article: http://betweenthenumbers.net/2011/10/proceed-with-caution-adjustable-rate-mortgages-gain-new-life/

1 comment

  1. Clement

    I would like to say thank you such a lot of for your work you have made in writing this piece of writing. I am hoping the same top work by you down the road too.

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