Monday, March 15, 2004

Greenspan May Not Be Right About ARMs

by Benny L. Kass

Question: We are first time homebuyers, and plan to stay in the new house for a long period of time. We have been offered two kinds of mortgages: a fixed 30-year mortgage for 5.5 percent with no points, or a 5-year adjustable-rate mortgage (ARM) at 4.25 percent, again with no points. We recently read that Alan Greenspan, the Chairman of the Federal Reserve Board, indicated his preference for an ARM. This has been a difficult decision for us, and we seek your opinion.

Answer: Mr. Greenspan's comments need to be carefully examined, because he did not categorically recommend the ARM mortgage over the fixed-rate loan. However, every homeowner has different financial needs and circumstances, and you must make up your mind based on your own personal situation -- but only after doing your homework, and "doing the numbers."

On February 23, 2004, Chairman Greenspan spoke to the Credit Union National Association 2004 Governmental Affairs Conference. His speech covered a broad range of topics, including mortgage financing. Here's what he stated about the ARM mortgage:

Recent research within the Federal Reserve suggests that many homeowners might have saved tens of thousands of dollars had they held adjustable-rate mortgages rather than fixed-rate mortgages during the past decade, though this would not have been the case, of course, had interest rates trended sharply upward.

American homeowners clearly like the certainty of fixed mortgage payments. This preference is in striking contrast to the situation in some other countries, where adjustable-rate mortgages are far more common and where efforts to introduce American-type fixed-rate mortgages generally have not been successful. Fixed-rate mortgages seem unduly expensive to households in other countries. One possible reason is that these mortgages effectively charge homeowners high fees for protection against rising interest rates and for the right to refinance.

American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage. To the degree that households are driven by fears of payment shocks but are willing to manage their own interest rate risks, the traditional fixed-rate mortgage may be an expensive method of financing a home.

Yes, he is correct that the fixed-rate mortgage may be an expensive method of financing a home, but it also might be less expensive -- depending on future economic conditions which are not within our control.

It should be noted that the Fed studies were made during the past ten years. And as anyone in real estate knows, interest rates started to fall in the late 1990's, and just two or three years ago, were at their all time low. What's the old adage: what goes down will ultimately go up?

How does the ARM work? When you get a fixed-rate mortgage, your interest rate stays the same for the period of the loan -- whether it is a fixed 30-year or a 15-year mortgage. With an ARM, on the other hand, the rate stays the same for the initial period, but then adjusts on a yearly basis for the remainder of the term.

There are a multitude of ARMs on the market, ranging from 6 months (which I adamantly oppose), to 1, 3, 5 or 7 years. I have even started to see a 10-year ARM.

Let's say you obtained a 5-year ARM in 1996 for 7.5 percent, in the amount of $200,000. For a full five years, your monthly payment would have been $1398. Beginning in 2001, your new mortgage rate would be based on an Index (usually a Federal Reserve Treasury rate), plus a margin of 2.75. The margin is perhaps the most important factor in an ARM, and (depending on the lender) will range from 2.5 to 3.5.

In 2001, the T-Bill index had dropped down to 6 percent. To determine your new interest rate, your lender will add your margin of 2.75. That means that your new rate for year 2001 will be 8.75, and your new monthly payment for that year will be around $1573. That's almost $200 more than you had been paying previously.

However, in 2002, the index dropped dramatically, down to 2.5. If you add the margin of 2.75, your new rate should be 5.25 percent. However, most ARMs will only allow a 2 percent increase or decrease on a yearly basis, and thus for year 2002, your new rate will be 6.75 percent -- and the monthly payment will be approximately $1295.

It should be noted that Mr. Greenspan added a significant caveat to his recommendations about ARMs. He specifically stated that if interest rates were going up, homeowners would not be saving money.

In the past several years, rates have plummeted sharply. People who had an ARM no doubt obtained some benefit from these falling rates. However, everyone -- economists and fortune-tellers alike -- are predicting that interest rates will be rising, especially after the November elections.

Thus, one should be especially cautious about obtaining an ARM in today's market.

Should you obtain an ARM? Ask yourself several questions:

  1. How long will I be living in the house? If you plan to live there only for a few years, then the ARM may be right for you. On the other hand, if you plan to stay put for a long period of time, the fixed-rate mortgage -- which is very low today -- is probably your best buy.
  2. If interest rates climb, will you be able to afford a higher monthly payment? What's your job situation? Is it stable? Do you get yearly increases? Will your family financial needs increase as the children grow older? Do you have money put away for that "rainy day?"
  3. And finally, are you risk adverse? Are you conservative or are you willing to take chances?

Chairman Greenspan opened the door for discussion about the ARM mortgage. He's a very competent economist. But he does not know your specific financial situation, and only you can make the decision as to what is right for you and your pocketbook.

Ask your lenders what the monthly payments will be on both loans which have been offered to you. Shop around -- both on the internet and on the telephone. Do the numbers, and calculate your financial needs.

Only then, can you make the educated decision as to what is best for you.

Published: March 15, 2004


At 9:38 AM, Blogger Jessica said...

ARM mortgage has advantages. With a lower adjustable interest rate the monthly amount will be less. You may therefore qualify for a larger mortgage or even bad credit mortgage, or you may qualify for a loan easier. Lenders use your gross monthly income and your monthly mortgage payment to determine how much you can qualify for. If current interest rates are very high, this could be the only loan choice available to you. But if you are risk avert, maybe this is not be the option for you.

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