Wrong-Way Borrowing Threatens Borrowers, Lenders
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Freddie mac figures show that as of September 18, 2008 you could get a 30-year fixed-rate mortgage for 5.78 percent plus .6 points.
How low is 5.78 percent? In June, 2003 we saw 5.21 percent plus .5 points — the lowest mortgage rate in 45 years.
This would all be encouraging except that it’s difficult to reconcile both low rates and the way many homes are now financed. If you have low interest levels then you logically lock-in those bargain rates and buy with fixed-rate financing.
Or do you?
An odd thing has been happening. For the past few years fixed-rate loans have been shunned. It’s as though they have cooties or some mysterious curse. Huge numbers of borrowers are opting for adjustable-rate mortgages — loans with low start rates but the potential for higher costs in the future.
It’s not just that ARMs are a huge and hulking portion of the mortgage marketplace at a time when interest rates are depressed, they tend to be the bigger loans.
Why is this happening?
Someone with a given income can likely buy or refinance more with an ARM then with fixed-rate financing because qualification standards tend to be more liberal. With an ARM it’s the borrower who pays more if rates rise. In comparison, if rates are fixed the lender has more risk because it cannot get a better yield if interest levels increase, so opportunities to maximize returns are lost.
You can see the ARM trade: Lower up-front costs and easier qualification standards for borrowers willing to accept the risk of higher rates in the future.
It has made great sense in the past few years to finance with an ARM because rates have generally fallen and home values have largely increased. Thus there has been an opportunity to buy an appreciating asset at little cost and with little risk.
Given little or nothing down, many buyers have been acquiring the largest home possible. If you buy a $200,000 home and the value rises 9.7 percent you’re ahead by $19,400. Stretch and buy a $300,000 home and your net worth would grow by $29,100. In this example, more is better.
This is all great and wonderful but there are two looming worries: First, home prices do not rise everywhere and certainly not when values are corrected for inflation.
Second, even if values do rise, home costs can also grow rapidly for those who have financed with ARMs. A $300,000 loan at 4.26 percent requires monthly payments for principal and interest of $1,475. If the rate a year later is 5 percent then the monthly cost rises to $1,608. At 6 percent, the monthly payment would be $1,796. (In practice the future costs would be somewhat lower because the principal balance is being reduced each month.)
You see where this is going. Six percent is a bottom-dwelling interest level by the standards of the past five decades. It’s not unreasonable to think that rates could “soar” to 6 percent — or higher. And it’s also not unreasonable to think that some of folks who are “in” at $1,475 will be “out” at $1,796.
Lenders may be using ARMs to offset future rate risk, but what about future asset values? Is it worth originating loans today which may sink lenders tomorrow? A large number of foreclosures won’t look good on anyone’s books, reason enough to tighten ARM loan standards.
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Published originally by Realty Times on June 7, 2005 and posted with permission.
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