PART TWO: “In Defense of ARMs”by Tim Manni
As promised, below is Part Two of Keith Gumbinger’s article “In Defense of ARMs”:
Value, and Opportunity
A product which offers a lower-than-market rate for a period of time offers both the promise of savings and an opportunity for homeownership which otherwise wouldn’t have existed. Even if 50% of all subprime ARMs failed (and some studies put it near those levels), that still leaves a 50% success rate — and lot of people owning homes who might not have become homeowners otherwise. Fixed-rate subprime loans were rare and expensive all throughout the housing boom, with rates in the high-single- and low-double-digit range. For borrowers, a high interest rate restricts the size of the loan one can qualify for; for lenders, a high interest rate means a increased likelihood of the borrower refinancing at some point, so few lenders were interested in making them available.
This being the case, it’s also necessary to segregate certain audiences.
Prime borrowers can choose to select an ARM if it fits their needs, while borrowers with weak credit histories have had little choice but to accept them if they wanted credit. This is a crucial distinction as well, since a sizable chunk of the jumbo mortgage market — loans made to the most well-off Americans — were ARMs, and by the choice of the borrower.
Payments, and Risks
It’s also worth evaluating the various payment structures overlaid onto ARMs. Some methodologies can compound the risk of ARMs… but these are payment choices, not mortgage products. A product which allows a borrower the chance to increase his or her loan balance, for example, a kind of increasing leverage over time, can have significant repercussions regardless of whether the product has a fixed interest rate or not. As well, even PayOption ARMs allowed the choice of a fully-amortizing payment.
Payments which require only interest for some period of time also have well-understood implications when they change to include the payment of principle (that is, they become fully amortizing). For the most part, these are are knowable outcomes; deferring payment necessary to amortize the debt — let alone not even paying all the interest which is due — can cause borrowers trouble when increases in the required payment occur, whether the underlying mortgage product is fixed or adjustable.
Whether anybody took the time to discuss these considerations and outcomes with borrowers when the product was being originated is a discussion for another day; both lenders and borrowers have responsibility in this regard. However, we need to keep in mind that available choices of payment methods aren’t themselves mortgage products — they’re an option that can be added to any loan, just as power windows can be added to any vehicle. It’s to those options, then, that the regulatory and legislative focus should turn. Any “consumer protection” discussion should center on whether the public would benefit from a regulation that residential first mortgage loans must not allow for negative amortization — or, perhaps, that the borrower must be qualified on the required fully-amortizing payment for the remaining term. To these could even be added other kinds of qualifiers, all to help ensure that the borrower can afford the loan under any realistic scenario.
It’s our opinion that homes and mortgages should never be sold solely on the basis of monthly payment alone. Of course, for a time, that’s just what happened. Promising a starry-eyed prospective homebuyer the chance to own a $400,000 five-bedroom colonial in the tony part of town for only a few hundred bucks per month is irresponsible, especially if that low, low payment lasted for just perhaps six months before the payments would increase.
In this way, borrowers who were allowed, prompted, or wanted to stretch their incomes to the limit just to qualify for the initial payment (or who were allowed to leverage their incomes into extra-large mortgages) were among those who shouldn’t have got an ARM — or, perhaps, any mortgage — as they were probably teetering on the edge of fiscal solvency to begin with.
There’s also something to be said about the frequency of interest rate changes. Even some venerable products are fading from the market as consumer interests have moved elsewhere. Short-term ARMs — those with up to a one-year interest rate change frequency — have, at times, caused borrowers trouble in times of quickly rising interest rates, since they can produce ever-higher monthly payments in rapid succession. There are good reasons why borrowers have gravitated to hybrid ARMs with longer delays before the initial adjustment occurs, chief among them the stability of the monthly payment for at least a reasonable time horizon (or for a desired time period).
-In case you missed Part One, click here to read it-