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August 6, 2004

A Shot in the A.R.M.

Everybody has their morning television preferences. I'm to the point where I barely pay attention to TV at all, but before work, just for kicks, I generally tune it to CNBC. (I derive great amusement from listening to analysts spout silly market and stock predictions.) Every once in a while somebody says something that catches my attention. Yesterday was one of those mornings.

One of the guests for Squawk Box's morning segment was mortgage guru Barry Habib, of CTX Mortgage. He wanted to talk about adjustable-rate mortgages (ARMs) in the context of a rising-rate environment. His opinion, if my sleep-clouded mind understood correctly, was that most people tend to discount ARMs if they think rates are rising, and that this shouldn't be the case. (One case where borrowers wouldn't automatically reject ARMs — rising rates or not — is when the bank won't qualify them for financing the house any other way. And that is a trainwreck waiting to happen.)

Even in a rising-rate environment, Habib said, homebuyers should seriously consider ARMs. They could potentially save borrowers thousands of dollars. There are a few catches, of course. They rest on these conditions:

(1) Practically nobody stays in a home longer than 10 years.

(2) Whatever monthly difference the borrower is saving by using an ARM as opposed to a fixed-rate mortgage (FRM) of the same term must be used to prepay principal on the loan. In other words, the borrower would take out an ARM, but make payments on it as if it were a fixed-rate mortgage of the same term.

(3) In 5 to 7 years, thanks to regular pay increases, the average homeowner's monthly income will have increased by at least 5 times what their ARM mortgage payment will increase.

Of course, Habib also dragged up Alan Greenspan's now-famous March 2004 admonishing of consumers for not utilizing ARMs more over the last ten years.

Let's be clear:   ARMs are drawn up to transfer the risk of interest-rate increases from the lender to the borrower. Mortgage brokers can sugarcoat this all they want, but it is that simple.

"The rate difference between a fixed-rate mortgage and an adjustable-rate mortgage can be properly viewed as an insurance premium that buys protection against future rate increases," writes Jack Guttentag, Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. (His website, MtgProfessor.com, is very worthy of a visit. Or ten.) Consumers who remember the monstrous inflation and interest rates of the early 1980s are likely to desire the protection that fixed-rate mortgages provide.

But Habib made an interesting case, and I wanted to see the math for myself. So let's assume we're looking at a $150,000 mortgage. Payments are monthly amounts, and reflect only principal and interest. Taxes, insurance, and PMI would be additional. A so-called "5/1 ARM" means that the initial interest rate is locked-in for 5 years, and is adjustable either up or down every 1 year thereafter. The starting numbers, with current rates, look a bit like this:

30yr Fixed5.65%$866
5/1 ARM4.62%$771 (first 5 years)

For the first five years of the mortgage, the ARM payment is $95 less per month. At the end of the fifth year, the balance remaining on the ARM loan would be somewhere near $136,984. The ARM holder would have paid $33,229 in interest so far. Conversely, the balance remaining on the 30-year fixed loan would be around $138,963. The fixed-loan holder would have paid $40,915 in interest so far. Thus, without making any additional payments to loan principal, the ARM borrower has saved $7,686 in interest over the first 5 years.

So let's take a look at the start of year six. Let's say that in the preceding five years, rates have risen such that the interest rate on the ARM will adjust 1.25 points higher at the start of year six. And let's say that our ARM borrowers had NOT followed Habib's strategy of making extra payments ($95 extra, in this case) on their mortgage each month for the first five years. Payments would look like this:

30yr Fixed5.65%$866
5/1 ARM6.27%$905

Five years into the mortgage, rates are 1.25 percentage points higher, and payments on the ARM are now a mere $39 more per month than on the FRM. Still, there is no assurance that rates won't move even higher in the following years. (Although most ARMs have a rate cap of either 5 or 6 percentage points above the initial rate; they are also usually limited in how much the rate can be adjusted — typically 2 percentage points either up or down — at any adjustment date.)

Now let's pretend that our ARM borrowers DID in fact prepay $95 extra per month on their ARM mortgage balance over the first five years, as per Habib's instruction. At the start of year six, their balance would be $130,585. Assuming the same now-higher rates as above, the payments would resemble:

30yr Fixed5.65%$866
5/1 ARM6.27%$863

Payment-wise, that $95 extra monthly kick-in nets the ARM borrower a negligible $3/month discount versus the FRM borrower. But in cumulative dollars, the FRM borrower has paid $40,915 in interest, while the ARM borrower has paid only $32,531. So the FRM borrower has paid $8,384 for the assurance that his payment isn't going to go up (at least, not due to rising rates). The ARM borrower has saved that money, but has no such payment comfort. Which means he cannot go to sleep at night knowing that this payment scenario isn't possible, say, by year ten:

30yr Fixed5.65%$866
5/1 ARM8.30%$1006

Considering that scramble of numbers, here are some of the possible hangups with Mr. Habib's "More ARMs Now!" endorsement:

  ARM terms vary widely, and can be stunningly complex.
There are only about 1,549 variations of adjustable-rate mortgages. While some are fairly standardized, in most cases lenders can pretty much make up whatever rules they want on these things. (Which is why ARMs are so often used to get subprime borrowers into homes they cannot really afford and have no business purchasing.) Some ARMs, for instance, are adjustable to prevailing rates as often as every month. Whiplash much?

NOTE: While I suspect that Mr. Habib's target audience on CNBC is fairly well-versed in mortgage workings, and thus more likely to understand the risks inherent in ARMs, it bears mention that a study by the Consumer Federation of America found that "lower-income and minority consumers are more likely to prefer ARMs, yet misunderstand the interest-rate risks of these mortgage loans." If you're not sure what terms like "negative amortization" mean, and some broker is suggesting you assume an adjustable-rate mortgage, well, you'd better do some homework. And quick.

  The spread in rates between ARMs and FRMs can vary widely.
Rates on ARMs and FRMs haven't always been as close as they are right now. Obviously, this is a case where you have to check the rates and do the math, because the difference in these rates is what brings about the big interest savings.

  We can count on our incomes rising over the years, right?
"Stronger economic growth in the economy will invariably translate into higher mortgage rates in the future, particularly for ARM products," said Freddie Mac chief economist Frank Nothaft in a July 2004 weekly report. "But this should be offset by job growth and by rising incomes nationwide." See that important word in there:   should?   Wrap your hands around it real good, because that is a heavy, heavy word.

And here's another heavy word that Habib didn't mention:   expenses. Kids, for instance, get older; years pass and the little cherubs need pricier clothes, high-dollar college, and bust-the-bank-account cars. Homes need furniture, repairs, maintenance. Cars fall apart, catch fire, and have to be replaced. As noted in "The Work 'n' Spend Cycle," because of items like these, expenses tend to rise to meet income. Counting on future salary increases to buffer you against rising rates, and therefore against a rising house payment, is a tenuous and risky position at best. Can you and your spouse also count on not being laid off? Disabled somehow? Ill for an extended period of time?

  Many people intend to make extra mortgage payments; almost none do so.
I read somewhere that something like a mere one percent of all homeowners make any extra principal payments toward their home loans. But I can't tell you how many people have mentioned to me that when they refinanced their homes the last time, they took out a 30-year mortgage but will be trying to pay it off in 15 years. Reality tells me that unless these folks somehow make it mandatory to send in that steeply-increased payment, they will find reasons not to do it. Just how much prepaying principal helps you depends on the interest rate you're paying, also. (The higher the rate, the more prepaying will benefit.)

  If you really want to save on mortgage interest, restrict yourself to 15-year loans.
One of Dave Ramsey's unpublicized financial rules is that people should never assume anything longer than a 15-year, fixed-rate mortgage. In his world, if you find a house you want but can't afford the payment that would accompany a 15-year FRM, then you can't afford that house.

Michael | August 6, 2004

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