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Federal Reserve Chairman Alan Greenspan is smarter than I am. This I acknowledge freely — not that there has been any serious debate on the question or is ever likely to be. And I’m not even particularly embarrassed by the confession. Mr. Greenspan, arguably, is smarter than most people. I
think it is also safe to assume that the
Fed chairman neither knows nor
particularly cares what I think about
the economy, the housing market, or
anything else. On the other hand, a lot
of people do know, and care a lot, about
what Mr. Greenspan thinks about almost
everything. So his recent comments
about adjustable rate mortgages (ARMs)
got a lot of attention. They also
demonstrated that the Fed chairman
doesn’t know as much about home finance
as he should. While he
What he said was that borrowers who obtained fixed rate mortgages over the past decade paid a high price for the security those loans provided and would have been far better off in most cases had they opted for ARMs instead. Mr. Greenspan also acknowledged that this would not have been the case had interest rates not fallen to their current extraordinary lows. Who Knew? As my teenaged daughter and her friends might say: “DUH!” Had borrowers known for certain that rates would fall and that their mortgage payments would decline accordingly, they might indeed have chosen ARMs and thus enjoyed the benefits of falling rates without incurring the costs or inconvenience of refinancing to reduce their mortgage payments. And had investors anticipated the stock market bubble, they might have avoided billions of dollars in losses when the market crashed. No one (including Mr. Greenspan) predicted the stock market bubble, nor did anyone predict the interest rate decline we have seen over the past 10 years; how could home buyers have anticipated it? Those who remembered the double-digit mortgage rates of the late 1980s, or who had read about that excruciating period of financial history, could hardly be faulted for at least considering the possibility that rates might follow the same pattern in the future. You
don’t have to go back 20 years to find
cause for interest rate concern. In
July of 1996, you could have gotten a
one-year ARM for 6.11 percent – a great
deal compared with fixed rates averaging
8.36 percent at the time. Your monthly
payments on a $200,000 ARM would have
been $1,213.28 compared with $1,518.03
-- a $304.75 per month difference that
would have netted you a savings of
$3,657.00 over the course of the year.
That would have been very nice, indeed,
but not so nice a year later when the
ARM rate would have jumped by two full
percentage points, boosting the monthly
payment to $1,482.89. It’s true you
would have saved several thousand
dollars in the interim, and it is also
true that your adjusted rate would still
have been a little lower than Unequal Benefits That’s the risk of an adjustable rate loan, and it’s not the same for all borrowers. What made Mr. Greenspan’s comments so disturbing, and so wrong, is his failure to note the very important distinction between borrowers for whom ARMs make sense, and those for whom that choice would be, not just inappropriate, but potentially devastating. Even Mr. Greenspan acknowledged a few days after making his comments that he had perhaps, “misspoken.” He had not intended to disparage fixed rate mortgages, the Fed chairman insisted; only to suggest that borrowers would be better served by a wider array of loan choices. In fact, the market is awash with mortgage choices. The point is, those choices are not equally beneficial for everyone. The
primary appeal of an ARM is the low
starting rate. The 30-year fixed-rate
mortgage was averaging 5.41 percent last
week but the one-year ARM rate has
fallen to 3.41 percent – the lowest
point since 1984 when Freddie Mac began
keeping track of rate movements. You
don’t need an economics degree to
recognize the appeal, but you also have
to recognize the risk that interest
rates, and the monthly payment on the
loan, will rise. Borrowers can reduce
that risk by selecting a “hybrid” ARM While hybrid ARMs seem to offer a mortgage equivalent of having your cake (a lower rate) and eating it too (a measure of payment certainty), they are not risk-free. For one thing, ARMs typically come with caps limiting the amount of a potential rate hike to no more than 2 percent at each adjustment and 6 percent over the life of the loan; but hybrids often have no limit on the first adjustment, which means borrowers might have to absorb the full lifetime increase, or a large part of it, all at once. On the $200,000 loan in our earlier example, the payments on a three-year ARM would start at around 4 percent. If the rate jumped by 4 percent in three years (unlikely, but not impossible), the monthly payment would go from $954.83 to $1,467.53, which would require a significant adjustment in almost anyone’s budget. And prepayment penalties on some hybrids could exact a huge price for refinancing before that time. Financial planners note that borrowers who invest the money they save by opting for an ARM, or who use the savings to accelerate the repayment of their mortgage, almost always come out ahead. But how many people will invest or save that money instead of spending it? And even those exceptionally disciplined borrowers still face the potential risks of rising rates, job losses, or salary reductions in an uncertain economy. ARMs also have some hidden dangers. Advocates argue that the lower initial rate increases a borrowers’ purchasing power, making ARMs a crucial financing tool when interest rates, home prices, or both, are rising. But that also makes ARMs a double-edged financial sword, slicing payments at the front end, but cutting deeply into the budget of buyers who are lured into buying homes more expensive than they can really afford. For many borrowers, buying a lower-priced house may be a far better response to rising home prices than obtaining a loan that masks the true costs and makes a higher-priced home seem more affordable than it really is. Assessing the Risks The risks of ARMs are real and significant, but so are their potential advantages for many borrowers. If you are certain you will move before the first adjustment, or if you know your income will rise substantially and steadily over time, then future payment increases hold no risks for you and an ARM of some kind is likely to be a better choice. However, if you know you’re going to be staying in the home you’re buying for a long time, if you are living on a fixed income or are uncertain about your future employment and/or salary prospects, or if financial risks of any kind make you nervous, you are far better off locking in a fixed rate with the knowledge that you can refinance to take advantage of future rate declines. If you are considering an ARM:
Pay close attention to Mr. Greenspan’s observations about the economic outlook, the impact of budget deficits, and inflation trends. But if you’re buying a house and wondering about how to finance it, maybe you’d better look elsewhere for advice. |
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may
be right most of the time about monetary
policy generally and about interest
rates specifically, he was wrong — or at
least terribly misleading — about ARMs.
the fixed rate alternative. But what if
you couldn’t afford to pay that
additional $300 or so every month? 
on which the rate is fixed for a
specified period, after which the loan
converts to a standard one-year ARM and
the rate adjusts annually. You can get
hybrids with fixed periods of three,
five, seven, or as long as 10 years; the
longer guarantee, the higher the
starting rate and the smaller the
advantage over the fixed-rate
alternative.