Lender propaganda campaign extolls adjustable-rate mortgages
What is the price for your soul? What would you have to be paid to advocate for something you knew was harmful? Would you feel comfortable creating ads for cigarette companies? Would you work for a lender making subprime loans or HELOCs? How dangerous does a product have to be before you couldn’t participate in its manufacture or distribution in good conscience?
Even writers and reporters face these dilemmas, particularly those who offer opinions to influence people’s decisions and behaviors. Because real estate agents historically spent millions on print advertizing, it’s rare to read negative stories about realtors or the health of the real estate market. With so much paid propaganda, they exert a subtle yet powerful control over the entire mainstream media. Many freelance writers publish puff pieces to give realtor propaganda the veneer of credibility it lacks otherwise. It isn’t only realtors who sponsor propagandist attempts to educate the general public with bad information and advice.
Today’s featured article is another attempt by the lending industry to convince people to use adjustable-rate financing. That form of financing provides a short-term improvement in rate while sacrificing long-term payment stability. Only the most foolish and short-sighted consumers benefit from these loans, but banks love them because it pushes interest rate risk on the consumer who doesn’t understand what that risk entails.
Conventional wisdom says go for a fixed-rate loan. For many people, that isn’t all that wise.
By SIMON CONSTABLE — Updated Nov. 10, 2013 4:19 p.m. ET
If you’re buying a home anytime soon, here’s some contrarian advice: Don’t take out a fixed-rate mortgage. If you do, you’re likely to pay more than you need to.
This is perhaps the worst and most misleading analysis I’ve ever seen. This embarrasses the Wall Street Journal to publish such a thing. They calculated the savings on the spread of the fixed rate mortgage versus the adjustable rate mortgage assuming the borrower wouldn’t refinance into a lower rate. Most fixed-rate borrowers refinance if rates drop, and nobody refinances their fixed-rate mortgage when rates go up. That’s the whole point in using a fixed-rate mortgage. Fixed-rate mortgage payments never increase unless the borrower increases the size of their mortgage.
Instead, it often makes more sense to choose a floating-rate note, also known as an adjustable-rate mortgage. Even on a small mortgage, over time you’ll save thousands of dollars. If you use the extra cash to pay down the loan, you’ll save even more.
Which, of course, nobody will. Like Option ARM teaser rate payments, 85% of borrowers only make the minimum payment all the time.
Such loans come in and out of fashion for a couple of reasons, says Frank Nothaft, chief economist at Freddie Mac. When rates on fixed loans are perceived to be low, borrowers tend to shun ARMs. When the difference between fixed and floating rates is small, again people tend to shun ARMs. Floating-rate notes are considered riskier than fixed-rate mortgages because the monthly payment can jump higher.
A so-called one-year ARM typically will reset each year based on fluctuations in the interest rate on the one-year Treasury security or the interbank cost of borrowing known as Libor. Other common ARMs reset each year after an initial fixed period of three, five or seven years.
A bomb with a long fuse is still a bomb.
Fixed-rate mortgages do make sense for some people. For instance, if your budget is so tight that even a small increase in your monthly payment would break the bank, a fixed-rate mortgage makes sense. A fixed rate would also make sense if you will keep your new home for a long time, like 30 years.
But for many people, ARMs come out ahead. Those people need to close their ears to the deafening sound of the ARM naysayers, like one financial planner I heard from: “You have got to be kidding. I guess a bad idea never dies. Don’t Americans ever learn?” I’ve withheld the name because I don’t want to embarrass him.
Give me his name. I want to promote him on this blog. He won’t be embarrassed; he will be embraced. The author of this article should hide his head in shame.
It’s true: Many people have been burned by ARMs. But as long as you are smart about it—more on that later—that financial adviser is wrong.
The main reason an adjustable rate will be cheaper is this: You almost certainly won’t be in your new house or apartment for the next 30 years, the typical life of a fixed-rate mortgage. Most people move every eight to 10 years, says Scott Buchta, head of fixed-income strategy at New York-based brokerage firm Brean Capital LLC. And even if you do stay longer than that, your mortgage won’t survive 30 years if you refinance at some point.
Borrowers will refinance less in the future. People simply don’t refinance when interest rates are rising because the long-term cost of money outweighs the short-term benefit. While people may not stay in the same house and pay the same mortgage for 30 years, it’s certainly preferable to have a fixed housing payment for as long as they stay.
That’s important because the main reason the rate on a 30-year, fixed mortgage is higher than floating rates is that the lender assumes you will take the full 30 years to pay it back. That puts the lender at risk of losing money on the loan if borrowing costs go up during that term. So the lender charges you more.
The premium is very small. In fact, many critics decry the 30-year fixed-rate mortgage claiming it would not exist outside of government guarantee. However, the FHA ran a self-sustaining program insuring fixed rate mortgages for more than 60 years without difficulty. If not for its use as the lender of last resort while the housing bubble collapsed, it wouldn’t need a bailout today. That strongly suggests that under normal circumstances the risk in 30-year fixed-rate mortgages is priced properly.
For that higher interest rate, you get a form of insurance: the security of knowing what your payments will be for the life of the loan. You can sleep better at night, knowing that if interest rates shoot higher, it won’t hurt you.
That’s exactly why everyone should use this form of financing exclusively.
But if you close out the loan in, say, 10 years—by moving or refinancing—you’ve paid too much for that insurance, because you were paying as though you needed 30 years of it.
Complete and utter bullshit.
Here’s an example of how much that can cost you. If you took out a 30-year mortgage in January 2003 the average fixed rate was 5.92%, according to Freddie Mac. Ten years of interest and principal payments on a $200,000 mortgage would have cost you $142,660. But if you went with a one-year ARM, which kicked off at 3.99%, according to Freddie Mac, after resetting each year the total cost would have been $119,181. That’s a savings of $23,479.
And if the borrower were stupid enough to keep a 5.92% fixed rate mortgage despite the numerous opportunities to refinance at much lower fixed rates, then their own foolish inattention cost them $23,479. It wasn’t the loan product that created that problem.
Really… Why do I need to point this out? Surely the guy writing this article sees how stupid and misleading his example is. This is what convinces me he must have sold a piece of his soul to write this garbage. I hope he was paid well. His real cost is hidden.
I can’t go on with this article. It annoys me too much. Read it for yourself. It doesn’t get any better.
Don’t use an adjustable-rate mortgage
Over the last 30 years of steadily declining interest rates, buying a house with an ARM didn’t create any long-term problems. Many buyers just waited for rates to go back down and refinanced into a fixed-rate mortgage. Some kept their ARM because the steadily dropping rates kept making their payment lower. Almost nobody recognized any risk to using an ARM because after such a long period of declining rates, everyone assumed rates would just fall forever — or for at least as long as they owned the property.
The problem with ARMs is only evident in a rising interest rate environment, and as I have discussed in numerous posts, we are at the bottom of the interest rate cycle, and rates are likely to steadily rise from here — perhaps for a very long time. Peak to trough on the interest rate cycle is usually 20 to 30 years.
Adjustable-rate mortgages have a contract interest rate that gets adjusted periodically based on the movement in some benchmark, often the federal funds rate or LIBOR. The promissory note usually has a contractual limit as to how high the rate can go, but the borrower is only qualified based on the initial contract rate. The assumption is that the borrower will see increasing wages, and if and when the rate goes up, they will be able to afford the higher payment.
This assumption carries hidden dangers. First, not everyone sees pay raises over time. Borrowers in their prime earning years may be maxed-out on the income they can be reasonably expected to garner. Second, even if the borrower does get raises, these raises may not keep up with the increasing cost of the mortgage. In either case, the borrower is either drained of all the benefit of their increasing pay, or they fail to keep up with the payments, go into delinquency, and end up as a foreclosure.
Perhaps the risk of ARMS will not be so great even if rates rise. Banks have become accustomed to giving loan modifications when borrowers can’t afford payments, and since loan modifications are the new borrower entitlement, people who foolishly take out ARMs at the bottom of the interest rate cycle will get bailed out by banks looking to avoid foreclosure. However, if house prices keep rising, and if the borrowers have any equity, the bank may not wish to extend a loan modification and may pursue a foreclosure instead.
Banks prefer borrowers to take out ARMs, particularly for the loans they keep on their balance sheets. ARMs pass interest rate risk onto the borrower. As long as the borrowers can afford the higher payments, and as long as the borrowers have equity that would allow the bank to foreclose, the bank really doesn’t care if the ARM becomes a hardship to the borrower; after all, it makes the bank more money.
Hopefully, borrowers are wise enough to take care of themselves. As you can see from the propaganda lenders are polluting the mainstream media with, they are taking care of themselves.
1311 North FRENCH St Santa Ana, CA 92701
$4,195,000 …….. Asking Price
$2,200,000 ………. Purchase Price
8/21/2002 ………. Purchase Date
$1,995,000 ………. Gross Gain (Loss)
($335,600) ………… Commissions and Costs at 8%
$1,659,400 ………. Net Gain (Loss)
90.7% ………. Gross Percent Change
75.4% ………. Net Percent Change
5.7% ………… Annual Appreciation
Cost of Home Ownership
$4,195,000 …….. Asking Price
$839,000 ………… 20% Down Conventional
4.89% …………. Mortgage Interest Rate
30 ……………… Number of Years
$3,356,000 …….. Mortgage
$863,242 ………. Income Requirement
$17,791 ………… Monthly Mortgage Payment
$3,636 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$874 ………… Homeowners Insurance at 0.25%
$0 ………… Private Mortgage Insurance
$0 ………… Homeowners Association Fees
$22,300 ………. Monthly Cash Outlays
($3,000) ………. Tax Savings
($4,115) ………. Principal Amortization
$1,580 ………….. Opportunity Cost of Down Payment
$1,069 ………….. Maintenance and Replacement Reserves
$17,834 ………. Monthly Cost of Ownership
Cash Acquisition Demands
$43,450 ………… Furnishing and Move-In Costs at 1% + $1,500
$43,450 ………… Closing Costs at 1% + $1,500
$33,560 ………… Interest Points at 1%
$839,000 ………… Down Payment
$959,460 ………. Total Cash Costs
$273,300 ………. Emergency Cash Reserves
$1,232,760 ………. Total Savings Needed