Profiting from adjustable-rate mortgages is lucky, not wise
Borrowers can save money in the short term with ARMs, but these loans carry significant risks, particularly when mortgage rates begin to rise again.
If someone buys in a cashflow property with an 8% yield, it’s an investment with a fairly predictable return. The soundness of the investment springs from it’s boring predictability, not from the more exciting caprice of resale price or speculation. Cashflow investments are wise, whereas speculative investments are lucky.
During the housing bubble, many people made a great deal of money because they had the good fortune to buy right before a financial mania took hold. Most participants thought they were savvy investors, but in reality, they were just lucky: they bought the right asset at the right time and rode the wave of appreciation.
Some of the really lucky ones sold their properties at the peak and converted that windfall to cash. Many foolishly lucky people serial refinanced every penny of equity out of their houses and left their lenders holding the bag. The unlucky ones are still trapped in their underwater castles.
Unfortunately, some people don’t recognize the difference between wisdom and luck, and like the gambler at the craps table that doens’t know when to take down his chips, the lucky think they are wise, so they keep letting their bets ride. Eventually, their luck will run out.
ARMs “Beating” The Market
Is your adjustable-rate mortgage (ARM) about to adjust? Consider yourself lucky.
Yes, lucky, not a sophisticated financial genius, lucky.
At current mortgage rates, today’s ARMs are resetting to all-time lows near 2.90%, proving that adjustable-rate mortgages can be financially-wise even beyond their initial 5- and 7-year teaser period.
No, it proves ARM borrowers can be very lucky if they happen to time their reset to an unprecedented time of deflation when the federal reserve feels the need to hold interest rates at zero percent for five years. If someone could see that coming, then yes, they are very financially wise.
Yet, homeowners appear eager to refinance their ARMs away.
Yes, most homeowners know they are picking up nickels in front of a bulldozer right now, and their luck is about to run out.
According to Freddie Mac, three-quarters of last year’s refinancing homeowners abandoned their ARM for something non-adjusting, such as a 30-year fixed or a 15-year fixed.
So, why do homeowners refinance ARMs into fixed-rate loans when mortgage rates for ARMs are so much lower? For some households, it’s a decision governed by fear.
You don’t have to rush to refinance an ARM. You may be wiser to just let it adjust.
Adjustable-Rate Mortgages : A Long-Term Winner?
An adjustable-rate mortgage is a mortgage for which the interest rate can change (i.e. adjust) over time based on “market conditions”. Sometimes, ARM mortgage rates adjust higher. Sometimes, ARM mortgage rates adjust lower.
Over long periods of time, ARM mortgage rates will often adjust both higher and lower.
Because ARM interest rates rise and fall over time, the product carries financial risk to households which use them. There is no way to know what your mortgage rate will be in 10 years, for example; or, in 20 years when your home finances may have changed.
Because of these uncertainties, carrying an ARM can be frightening.
It can also be rewarding.
Consider that over the last 12 years — beginning in 2003 — nearly all U.S homeowners who financed their home with a conventional ARM have “beat the bank” on their mortgage. Adjustable-rate mortgages have adjusted lower year after year and, today, adjustable-rate mortgages are adjusting to their the lowest levels in recorded history.
This is the poor analysis everyone who supports ARMs falls back on, and it ignores one very inconvenient fact: borrowers with fixed-rate mortgages can refinance into a lower rate mortgage when rates go down, so fixed-rate borrowers get the best of both worlds: fixed-rate borrowers gain advantage when rates go down, but they pay nothing extra when rates go back up.
In all, you have three options for your adjusting ARM :
- Do nothing. Let your loan adjust lower; revisit mortgage rates again next year
- Refinance your ARM to a new ARM at today’s low ARM mortgage rates
- Refinance your ARM to a new fixed rate loan at today’s fixed rate pricing
Each option has merits.
If you allow your ARM to adjust, your lender will assign a new mortgage rate based on today’s LIBOR. Most homeowners will get a rate of 2.91% which will be good through November of next year. The payment on a 2.81% mortgage rate is $417 for every $100,000 owed.
You can also refinance into completely new adjustable-rate loan. …
Lastly, you have the option of switching your ARM into a fixed-rate loan.This is the most common way homeowners remove the uncertainty of “changing mortgage rates” and, according to quarterly refinance reports from the government, 75% of homeowners with ARMs make this choice.
One-quarter of ARM-holding homeowners refinance back into an ARM.
Using an ARM or a fixed-rate mortgage is much like the debate between actively trading securities or merely buying an index. People who use ARMs, much like people who actively trade, can gain a small advantage if they time the market well — and of course, if they get lucky. People who don’t have the time, inclination, or expertise to actively manage their mortgage debt, much like people who passively invest in market indices, are generally better off getting a fixed-rate mortgage.
The savings on ARM payments are tempting, and during the first five years of the loan, if the borrower is disciplined enough to make larger payments, they can pay down their mortgage quicker. If they get lucky, and if mortgage rates are still low in five years, they may be able to get into a fixed-rate mortgage then and be ahead of where they would have been if they took out a fixed-rate mortgage from the beginning.
Do you have the time, expertise, and inclination to manage your mortgage debt that closely? If so, you may be able to save money with an ARM; however, if rates move much higher over the next five years, you may find yourself facing much higher payments and even worse off than if you had used a fixed-rate mortgage from the start. For that reason, I don’t recommend using ARMs.