October 3, 2022

The Pros and Cons of an Adjustable-Rate Mortgages (ARM)

A mortgage payment is usually the biggest monthly expense for most people.  Since an adjustable-rate mortgage (ARM) will always start off with a lower rate than a fixed rate mortgage, it is useful to understand the pros and cons of an ARM.  Depending on the trends of future interest rates, an ARM can be a money saver or a money pit.

The interest rate on an ARM can change over the life of the loan at various time intervals depending on the type of mortgage product you select.  An ARM product is more challenging to understand than a fixed rate mortgage so dealing with a knowledgeable mortgage loan officer is essential.  The rate on an ARM is the sum of an index rate plus a fixed margin.  The index rate will vary but the fixed margin will not.  Most banks use a short-term index rate such as the yield on a one year Treasury bill.  The index rate plus the margin is called the fully indexed rate.  The ARM will never have a rate less than the fixed margin.  For example, if the fixed margin is 3% and the yield on the one year treasury is 0%, the ARM will have a rate of 3%.

The typical ARM rate will change yearly. The date of the first-rate change on an ARM depends on the type of ARM that the borrower initially selected. The four most common ARMs are the 3/1 ARM, the 5/1 ARM, the 7/1 ARM, and the 10/1 ARM.  These ARM products are called hybrid ARMS since they have a fixed rate for the time specified and afterwards convert to an adjustable rate which can change once a year.  For example, the 3/1 ARM will have a fixed rate for three years and the rate might change starting in year four.  The starting rate on loans with a longer initial fixed interest rate will start off higher.  For example, the rate on a 5/1 ARM might start off one percentage point lower than the start rate on a 10/1 ARM.

ARM products have lifetime and yearly rate caps.  Although the rate change on an ARM can be substantial over the life of the loan, lenders have a cap on the yearly rate increase to avoid payment shock to borrowers, but the lifetime rate increase can result in much higher payments.  Most ARMs cannot increase by more than 2 percent after the initial fixed rate period and the lifetime rate is usually capped at 5 percent above the start rate.  For example, in a worst case basis a borrower with a 5/1 ARM at a 2.75% start rate might see an increase to 4.75% in year six, 6.75% in year seven, and reach the lifetime cap of 7.75% in year eight.

The risk involved with an ARM should be carefully considered.  An initial interest rate that is lower than a 30-year fixed rate is a bet that future interest rates will not dramatically increase.  This has been the case for the past 14 years and the ARM borrower automatically shifted to a lower rate without the large expenses involved in a refinance.  However, even if rates do increase in the future, savings from a low start rate could more than offset higher rates in later years.

No one can predict future interest rates but in a declining or stable interest rate environment, ARM borrowers will save money over time compared to a fixed rate mortgage which almost always has a higher rate than the start rate of an ARM.

An ARM will make sense for a borrower who expects to sell his home within 10 years which is the average number of years a person lives in his home before selling it.

FHA Mortgages and Student Loans Are a Risky Combination

First time home buyers have traditionally faced a variety of obstacles including the high cost of housing, stagnant wages, and the difficulty involved in saving for a down payment.

 

If that wasn’t bad enough, recent changes by the Federal Housing Administration (FHA) now raise another potential barrier to home ownership due to the manner in which student loan debt must be evaluated.

 

For a variety of reasons many potential home buyers with a large load of student debt are able to obtain payment deferments of various durations.   Since there was no formal payment due under the payment deferments, some of which can last for years, the FHA had for the most part simply ignored the looming certainty of future monthly payments.  By not factoring in an estimated loan payment for deferred student loans, borrowers were able to lower their debt ratios for purposes of loan eligibility.

With the new FHA requirement to account for future payments on deferred student loans, many applicants may wind up with a back end debt ratio in excess of the 43 per cent currently allowed under FHA regulations.  Potential home buyers who were close to the maximum for monthly debt payments may now find themselves ineligible for any type of mortgage loan.

Are the new FHA regulations fair to first time home buyers?

One could make the argument that the new rules make sense since at some point the borrower is going to be required to start making payments on the student loan debt and if the payment is large enough it could cause enough financial stress to put the borrower at risk of defaulting on the mortgage.   According to a HUD spokesman,  “Will that borrower actually be able to afford their loan and the student loan payment? It’s a legitimate issue to consider.  Deferred student debt is debt all the same and really must be considered when determining a borrower’s ability to sustain both student debt payments and a mortgage long term.  Our primary interest is to make certain that a first-time home buyer is put on a path of sustainable home ownership rather than being placed into a financial situation they can no longer tolerate once their student debt deferment expires.”

It’s difficult to dispute the logic of HUD’s position but it seems to fail to take into account the prospect of a borrower’s future income increasing enough to compensate for the additional student debt payment.

The problem with considering future income, however, is that incomes have been increasing at a very slow pace in the post financial crisis period.  The prospects of higher incomes for the average worker remains speculative while the certainty of having to make payments on a student loan at some point are not.  Nonetheless, the increase in the amount of student loans being handed out have been increasing at a staggering rate as students furiously borrow on the dubious prospect of obtaining a job after college that pays enough to buy a house and car, raise a family, and payoff student loans.

Those expecting an increase in the rate of home ownership are likely to be disappointed as more and more young people remain at home with their parents unable to take on the financial responsibilities of home ownership.

The excessively easy lending of a decade ago temporarily raised the rate of home ownership as totally unqualified borrowers bought houses on the theory that home values could only continue to skyrocket.  The subsequent default of these weak and unqualified borrowers resulted in millions of foreclosures which burst the housing and mortgage lending bubble which resulted in the rate of home ownership falling right back to the long term historical average of about 65 per cent.

The Zero Sum Game Of Lower Interest Rates And Why Mortgage Rates Will Rise

The Federal Reserve has forced long term interest rates to historic lows in a desperate attempt to “stimulate” both the housing market and the economy in general.  The results have been mixed but the benefits of lower rates to borrowers are undeniable.  Lower rates reduce the cost of large debt burdens carried by many Americans and increases the spending power of those able to refinance.

Exactly how much lower the Fed intends to repress mortgage rates is anyone’s guess but as interest continue to decline, the overall benefits diminish.  Here’s three reasons why the Fed may wind up discovering that the economic benefits of further rate cuts will be muted at best, self defeating at worst.

1.  Lower rates are becoming a zero sum game for the economy as lower rates for borrowers translates into lower income for savers.  Every loan is also an asset of someone else and lower interest rates have merely been a mechanism for transferring wealth from savers to debtors.  Every retiree who prudently saved with the expectation of receiving interest income on their savings have been brutalized by the Fed’s financial repression. Even more infuriating to some savers is the fact that many debtors who took on irresponsible amounts of debt are now actually profiting from various government programs (see Foreclosure Settlement Q&A – A Victory For The Irresponsible).

A significant number of retirees that I know have been forced to drastically curtail their spending in order to make ends meet while others have been forced to draw down their savings.  The increased spending power of borrowers has been negated by the reduced spending power of savers.  This fact seems to elude Professor Bernanke who hasn’t been able to figure out why lower rates have not ignited the economy.

2.  Many consumer who would like to incur more debt are often turned down by the banks since their debt levels are already too high.  Those who can borrow often times chose to deleverage instead, considering the fragile state of the economy.  Anyone saving for a future financial goal (college tuition, home down payment, retirement, etc) is forced to reduce consumption and increase savings due to  near zero interest rates.  The Federal Reserve has destroyed Americans most powerful wealth building technique – the power of compound interest.  A 5% yield on savings will double your money in about 14.4 years while a 1% yield will double your money in 72 years – and that’s before taxes and inflation.

3.  As mortgage rates decline into uncharted territory, the mathematical benefit of lower rates diminishes.  As can be seen in the chart below the absolute dollar amount of monthly savings as well as the percentage decrease in the monthly payment diminish as rates race to zero.

Benefits of a refinance on a $200,000 mortgage diminish as rates decline

% Rate Mo Payment Mo Savings % Reduction Yearly Savings
6.00% $1,199.00
3.00%    $843.00 $356.00 29.70% $4,272.00
1.50%    $690.00 $153.00 18.10% $1,836.00
0.75%    $621.00  $69.00 10.00%    $828.00

Closing costs at lower rates also become problematic, making it impossible to recapture fees within a reasonable period of time.  With closing costs of $8,000 on a $200,000 mortgage refinance, it would take a decade to recoup closing costs.

Many astute analysts have made elaborate and compelling arguments that interest rates can only go lower.  From a contrary point of view, I believe that a future rise in interest rates is a high probability event.  This is the opposite of my prediction in March 2009 when I surmised that mortgage rates would decline to 3.5% – see 30 Year Fixed Rate of 3.5% Likely.

The Chart of the Day has a long term chart of the 10 year treasury and notes that the recent sharp decline in interest rates “has brought the 10-year Treasury bond yield right up against resistance of its 26-year downtrend channel.”

 

Treasury Officials Announce Mortgage Holiday

News Release: Sometime in 2010.

The United States Treasury Secretary is expected to release details today of the Government’s plan to suspend for one year all payments due on mortgages secured by single family residences.  The Government announced that it was taking this action due to unprecedented conditions in the economy and record numbers of mortgage delinquencies.   With close to half of all mortgages in arrears, a jobless rate approaching 20% and retail sales collapsing by double digits for the third consecutive year, the latest government move to boost the economy was applauded by analysts as the best direct method of putting funds in the pocket of cash starved consumers.

Government officials noted that since most of the mortgages affected had already been purchased or guaranteed by the US Government, there would be no direct cost to the taxpayer.  Analysts noted that this latest move was necessary after a long series of loan modifications for many borrowers had failed due to the continued decline in housing prices and incomes.  Brushing aside suggestions that this program was unfair to those who had no mortgage debt, Treasury officials stated that the program was initiated to help those most in need and that those without mortgages might be eligible for funds under the latest rebate stimulus plan.

In response to questions as to whether or not the Mortgage Holiday Plan might be extended beyond one year, Treasury officials stated that the Government would do everything in its power to assure that affordable housing was available to every citizen and that every measure would be taken to prevent homeowners from losing their homes due to unaffordable payments.

The Treasury Secretary noted that while many sovereign nations had become insolvent due to the ongoing financial crisis, the United States remains “fiscally strong”.

So there you go; congratulations to the Federal Reserve and our fiscally imprudent leaders who have brought this nation to the brink of economic collapse.

    Some Borrowers Will Need Very Large Loan Modifications

    As discussed in a previous post, Bank of America agreed with the state attorneys general to offer  concessions to 390,000 sub prime and pay option arm borrowers by reducing both the principal owed and/or the interest rate to a level that allows these borrowers to have a an “affordable and sustainable” monthly mortgage payment.   An affordable and sustainable payment was determined to be a mortgage payment (including taxes and insurance) that would not exceed 34% of gross monthly income.   With this agreement apparently setting a standard for future concessions to homeowners, consider some recent mortgage transactions/applications that I have seen.

    • Woman wants to refinance her Connecticut home which she bought in early 2006.  The home today would probably sell for no more than $260,000.  Home was purchased for $305,000 with 95% financing; the current interest rate is at 11.625% and she owes $285,000.  The negative equity is only $25,000.  Borrower has a gross monthly income of $3780 per month and her current monthly payment of principal, interest, taxes and insurance is $3682 giving her a debt ratio of 97%.   She is currently in arrears on the mortgage and obviously not capable of making the payment.   In order for her payment to become “affordable and sustainable”  with a 34% debt to income ratio, the lender would have to reduce her loan balance to $158,000 with an interest rate of 1%.

    If the home owner gets this deal, not only would her payment become affordable, she could also sell the house and reap a gain of $102,000.  The applicant’s income is about the same today as it was when she purchased the home, so there was no drastic decline in income.  Obviously, this woman should have never been approved for a mortgage in the first place; both the bank and borrower knew this.

    • A self employed carpenter applied for a mortgage to purchase a home for $185,000.  Applicant has no credit score since he pays for everything “in cash”.  The yearly income reported on his tax return for the past two years averaged $5500.  When I told the applicant that he did not qualify he became indignant and arrogantly proclaimed that his bank told him they would approve him; I wished him good luck.  This guy hasn’t been reading the papers lately but the days of borrowing based on what you say your income is are over.   The applicant understood his situation; his income averages $458 gross per month according to his tax return and the monthly mortgage payment with taxes and insurance would have been at least $1650 per month which he insisted he could afford.  I would say that the IRS should conduct more audits of self employed individuals.
    • Borrower with very good credit and working two jobs has a sub prime mortgage and applies for a lower rate under the FHA mortgage program.   Borrower gets approved with with a debt to income ratio of 56%.  At this point, instead of bringing his lunch to work everyday, he might be better off to stop paying on his mortgage and  ask his bank for a loan modification once he is delinquent.  The interest rate would need to be reduced  from 6.25% to 1% which would put him at the recommended 34% DTI.  Although most loan modifications are currently being offered only to sub prime and pay option arm customers, I am certain that in the name of equitable treatment, the offer will expand to include the multitudes of other borrowers with a debt ratio over 34% .  Why discriminate against better credit borrowers?
    • Borrower with fair credit purchases a home with 100% FHA financing with the help of a down payment assistance program.   Borrowers debt ratio at time of approval was 48%, which is extremely high and not affordable or sustainable for very long.  Why is the FHA approving loans at this ridiculous debt ratio when the state attorneys general are forcing Countrywide to modify loans to a debt ratio of 34%?  I suggest that a state attorney general be named Head Underwriter for the FHA.

    I could go on and on, but one thing is for certain; there are millions of home owners currently in a stressed income situation with negative home equity who would like to refinance but can’t due to low credit scores/lack of home equity or both.   As word spreads of the great deal that Countrywide borrowers got from the recent Bank Of America settlement, there will be many indignant and angry home owners demanding the same treatment.   Can the banking system, already insolvent, handle huge new write downs?