They're back. Sort of. After all but disappearing when the real estate bubble burst, adjustable rate mortgages (ARMS) are staging a comeback. Falling to about one percent of all mortgage applications in 2009, adjustable rate mortgages now account for about six percent of the market, and just this past weekend The Wall Street Journal weighed in with a piece titled Home Loans: A Call to ARMS? that led with the news that "Adjustable-rate mortgages, out of favor for years, are looking like a deal." From my vantage point, though, they look like the wrong kind of deal.
The Case Against Adjustable Rate Mortgages
- There's a much better alternative. A 30-year fixed rate mortgage these days comes with a super low 4.7 percent interest rate. That in itself is plenty of reason to forget about an adjustable mortgage. To be able to lock in absolutely no future rate risk at such an affordable rate is a really good deal. Yes, I know that a 5-year ARM is an even better deal, clocking in at an enticing initial rate of 3.4 percent. That puts the spread between a 30-year fixed rate and a 5-year ARM at more than double its historic norm. Thus the latest trickle of articles tiptoeing around the idea that ARMs are worth looking at. If we were talking about a 30-year fixed at 8 percent or 9 percent, I'd be the first to walk through the math of ARMS and suggest how to weigh the risks of future adjustments. But at 4.7 percent? No thanks. I'll take a really good deal that stays a good deal no matter what, over a great deal today that can turn on me.
- Is your home really where you should be taking risk? I want to be clear, the market for ARMs today is totally legit; there are no interest-only and option-only ARMS, the most toxic of the bad loans that abounded during the housing bubble. The ARMS of today are absolutely kosher. The two most popular versions are the 5-year ARM and a 7-year ARM, where the interest rate holds steady for the first five or seven years before it can adjust. But I'm still not biting. Yes, I am well aware of all the reasons why this can work to your advantage:
- You'll move before the first adjustment hits.
- You'll refinance if rates start to rise.
- You'll cover the higher payments with your much higher salary five or seven years from now.
Perhaps one or more of these things will happen, but perhaps they won't. That's one (and just one) of the more important takeaways from the housing debacle: Things didn't exactly play out how folks expected. Jobs were lost. Equity evaporated, rather than grew. And median household income hasn't really budged in the past 10 years. Seems like a fair amount of risk to be taking when the no-risk option costs you just 4.7 percent.
And I'd be extra careful thinking you'll simply move ahead of any rate adjustment. A study by the National Association of Homebuilders a few years ago found that nearly 70 percent of homeowners are still living in the same home after seven years, and 75 percent after five years. I suspect those numbers will increase going forward, as more moderate price appreciation will put a damper on quick trade-ups. If you are absolutely positively sure you're going to be in the other 25-30 percent, the gamble may be worthwhile. But just think through the potential scenarios if your plans change on you.
- Interest rates are at a cyclical low. General interest rates and mortgage rates have been in a long consumer friendly slide for thirty years. A 30-year fixed rate mortgage had an interest rate of 18.45 percent in October 1981. That's not a typo. It took another 10 years for the rate to get below double digits. And as recently as 2000, a 30-year mortgage under 8 percent was a really great deal. So with that bit of historical perspective, 4.7 percent today should be seen for what it is: very, very low. Sure, it could stay low for a while. Maybe even go lower. But if you are betting on where things will be five years or seven years out, you need to respect that what is happening right now is an aberration borne of Federal Reserve policy to keep the economy from sputtering out. They can't do that forever. At some point, rates will indeed head higher. No one has any idea how high. But just keep in mind that on a typical 7-year ARM the first adjustment can be as much as 5 percentage points, if that's what the underlying index calls for (that five percentage points is also the maximum lifetime adjustment on the loan.) So that puts you at 8.3 percent. Historically, that's not bad. Or you could sleep easy by simply locking in 4.7 percent forever. That's not exactly bad, either.
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