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Riskology

Seduced by risky adjustable rate loans — again

About the author

Ari has written about financial products and investing for The Wall Street Journal, Forbes, and Pensions & Investments. Find him on Twitter.  

(Harley Schwadron)

(Harley Schwadron)

One hallmark of last decade’s go-go housing market: the willingness of buyers to base their purchase on a gamble.

When house prices did nothing but climb, some people in many parts of the world took the cheapest mortgage they could, envisioning juicy returns on their equity. For less credit-worthy borrowers and house flippers, new-fangled adjustable-rate mortgages were the financial product of choice.

While demand for the most obscure products — and the willingness for banks to lend to less-than-credit-worthy borrowers — has been largely wiped from the market, “traditional” adjustable-rate mortgages have made a quiet comeback in the US and never fell out of favour in many other countries.

ARMs, as they are known, often feature low fixed rates for between one and 10 years. It’s easy to see why that’s attractive to prospective buyers—pay less now and get a more expensive home than you can afford otherwise. These became wildly popular during the housing boom. After all, home prices were only going up, up, up. What could go wrong? It was easy to forget during the fixed period, these loans reset to the prevailing interest rate — with some limits.  

Indeed, too few borrowers and too few lenders thought much about the big reset. Though rate increases are capped for ARMs, many people learned the hard way that there’s a real potential for, well, big problems. Remember 2007? 2008? Home values plummeted and many borrowers suddenly found themselves with mortgages that were significantly more than their home was worth. Forget about refinancing into a more affordable fixed-rate loan—no bank is interested in lending more than a home is worth. Although aggressive government policy action helped some borrowers, for most, the ARM rate resets that followed the plummeting values forced higher payments at a time when job losses or salary cuts were mounting.

ARMs all but disappeared in the US as conservative borrowers were spooked. (Borrowers in stronger markets, however, and those with plenty of cash, stuck with ARMs, opting for cheap money instead of selling assets from investment accounts that had higher earning potential if left alone.)

Fast forward to 2013. Healthier economies have pushed long-term interest rates higher and home prices have begun to climb, making those lower short-term fixed rates seductive once again and challenging our collective memories of the pain that came with them. ARMs are creeping back into the lexicon with less negative connotation. But the question remains: would you rather gamble that rates will remain fairly steady or go down in the next few years? Or make the slightly more expensive, but safe, bet?

Following one of the greatest living lessons in leverage, the choice should be clear. But, that doesn’t stop some people from taking their chances.

“Right now, clients have to convince me why an adjustable rate mortgage is right for them,” said Craig Stelzer, a vice president at WCS Lending in Boca Raton, Florida.

Otherwise, he said, the money saved by taking a 7-year ARM against a 30-year fixed rate mortgage is hardly enough to pay for the risk. For example, the monthly payment on a $300,000 fixed-rate 30-year mortgage at 4% would be $1,432. An ARM, fixed over 7-years at 3.5% and then floating would run $1,347. And about that rate reset — if interest rates go up, as expected, that $1,432 payment might look awfully nice to have had down the road.

Retrain your brain to dis-ARM

In many countries where ARMs and very short-term fixed mortgages are the standard, adjustable rates are viewed as enforcing financial discipline through uncertainty — knowing you will have to potentially pay more later, you are more likely to save now.

The US is largely unique for the dominance of long-term fixed rate mortgages, however, and ARMs have traditionally attracted those who are “budgeting for what they can most afford now,” said Robert Schmansky of Clear Financial Advisors in Detroit. “Many (people) are not even aware that they are taking a gamble.”

Why not? Well, our ability to imagine 5-to-7 years into the future, that time when rates adjust and our payments will possibly go higher, is difficult.  

Widely-cited work by New York University’s Yaacov Trope and Nira Liberman of Tel Aviv University shows that it’s easier to see the short-term benefit of lower payments than to imagine scenarios and states of the world further out. What’s more, to really assess the future—for any sort of financial planning—you have to be able to wrap your brain around a broad range of possible scenarios and states of the world.

That’s the kind of long-term thinking at which most of us hardly excel.  So, how exactly, do we train ourselves to think long-term?

In the fixed- or adjustable-rate mortgage debate, SmartAsset, a New York-based company designing interactive financial calculators, draws on a pool of real mortgages and presents to its clients a breakeven point using the worst case scenario for the future rate adjustment. Right now, that could be enough to shake even the most ARM-seduced borrower since the savings barely make a dent compared to the possible pain down the road.

“There is no perfect mortgage,” wrote Dr Michael Lea , Director of the Corky McMillin Center for Real Estate at San Diego State University in a 2010 report for the US Mortgage Bankers Association and the Research Institute for Housing America that looked at product offerings across 12 major developed countries.

So, for homebuyers currently in the purchase or refinance market, a long-term view of the risk in your payment structure should help steer you in the right direction. Some ideas to consider:  

  • Would I make a 15- or 30-year commitment to myself, based entirely on the notion that I can make cheap payments now?
  • Does it make sense for me to pay a little more for a few years to guarantee steady payments for 15 or 30 years?
  • If my situation changes, could I afford any prepayment penalty?

As the past 3 months have shown, interest rates can move hard and fast, out of the reach of even the most aggressive central bankers. The rate on 10-year US Treasuries, the benchmark rate for long-term fixed rate mortgage products in the US, has moved to 2.88% from 1.84% at the beginning of the year.

And if you think you know for certain which way rates are headed next, then I have just the mortgage for you.

Take the sure thing.

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