PART FIVE: “In Defense of ARMs”by Tim Manni
Here is the final piece to our five-part article “In Defense of ARMs”:
The coming need for ARMs
For the moment, interest rates are low. We can assure you with 100% certainty that this will not be the case forever. While no one knows how high interest rates may go during an economic cycle, there are growing concerns that the “pull-out-all-the-stops” methods employed to cushion the economic downturn may turn into a nasty spike in inflation.
An inflation spike will push up interest rates, particularly long-term interest rates — like those found on, say, 30-year FRMs. With the housing market expected to be in a fragile state for some time, and with low interest rates a key component of recovery for housing, what would happen to the housing market if interest rates visit 7% or 8% — or even approach 9%, as they did in the beginning of this decade?
Absent ARMs, how severe might the collapse in home sales be?
As “affordability” is the intersection of a home’s price and financing costs, how much might demand for housing and home prices be crushed (again) with fixed-rate mortgages at 8% and no lower-cost options available? The difference in the amount of mortgage you can borrow at 6% versus 8% is substantial, and the home sale market can only function if borrowers can afford to buy. Without ARMs, there will be no lower-cost options available, and the market would probably come to a complete halt until either incomes rose or prices fell… more likely, a combination of both.
It’s also worth noting that ARMs can be a useful tool for spurring the housing market. New home sales have been weak for several years, and builders are holding a fair bit of hard-to-move existing inventory. A major national builder recently began offering a 7/1 ARM with an interest rate of 3.875% — more than a percentage point and a half below even conforming 30-year FRMs — to buyers of its houses.
Over a period of seven risk-free years, a borrower who took that 7/1 over a comparable 5.5% 30-year FRM with a $250,000 loan amount would save some $244 per month — about $28,000 in total interest costs over 84 months — while also retiring some $7,500 more of the loan’s principle balance over that time compared with the 30-year FRM.
ARM critics will note that “anything can happen after that!”, and to a degree, that’s true. However, nothing prevents the borrower from refinancing out of that ARM without penalty at any time… and it’s also quite possible that the borrower will have closed out the loan by moving, too. “Anything can happen!” is true, but we’d also like to see even a grudging acknowledgment that there may be positive, risk-free outcomes, too. As the risks are knowable, they might even be ameliorated to a great degree with a little bit of disciplined planning on the borrower’s part.
How many ARMs succeeded over the years?
While critics are quick to point out how many ARMs have failed in this “perfect storm” of liberal lending policies at a time of rock-bottom interest rates, the fact is that many ARMs did not. There probably have been many millions of success stories over the 25-year history of the product, and many homebuyers and refinancers have enjoyed opportunities for homeownership and saving money that ARMs have provided.
Still think they’re “toxic”?
A wide range of available choices in mortgage financing benefits everybody. It serves to help promote housing demand, which keeps home values firmer than they would otherwise be. At their core, ARMs remain valuable to specific audiences who can and have used them to great effect over the years. In this way, they are a ‘niche’, product, no different than any other ‘niche’ product. It is only when the those outside the ‘niche’ either stumble or are crammed into it does it create a problem, for lender and borrower alike. It is a fact that certain mortgage choices are intended to fit certain applications, and regardless of the product, issues will arise when an improper choice is made.
While we don’t think ARMs are toxic or evil, we would agree that there needs to be a better, clearer and simpler way of disclosing how a given product will work — in best-, typical- and worst-case scenarios. We think loan documents need to be much more explicit in how a borrower might be harmed, particularly if an ARM is coupled with any form of non- or partially-amortizing payment method. We think that no mortgage should be sold solely on the basis of initial monthly payment, let alone see borrowers qualified at artificially-low interest rates.
However, we do believe in choice, albeit informed choice, and we do believe that innovation and evolution of mortgage products matters. Just as certain products in the mortgage markets have come and gone — due to consumer and lender choice (two-step balloons, anyone?) — we think which products survive and which do not should come as part of that natural process of the marketplace weeding the ‘good’ from the ‘bad’. We would hate to see innovation or consumer choice quashed by regulators over-reaching in the name of “consumer protection”.
What’s your opinion? Agree? Disagree? Are you a success story?
-Check back in with us tomorrow to read the article in its entirety.