Is history doomed to repeat itself?

I was going through my daily news feeds and noticed this article. The title was “Adjustable Rate Mortgages are Back.”

I literally had to pause for a few seconds to think about it. Are they really back? Further reading into the article states some interesting statistics:

After accounting for nearly 70% of all mortgages issued during the boom, ARMs vanished during the bust, totaling just 3% of the market in 2009. Now they make up 5% of all mortgages issued, and Freddie Mac predicts 10% by December.

While I wouldn’t exactly say they are coming back, the projection of the amount of ARMs to double by this December is a bit unsettling. Are people starting to forget that ARMs were one of the main ingredients in sustaining the housing market crash?

The terms of an ARM do look enticing, especially considering the economic situation of many. Let’s take a look at some of the important details of an ARM:

——————-

source

Fully Indexed rate – the rate you must pay, barring any periodic caps, in order to fully amortize or pay off the loan.

Margin – the fixed component of your ARM loan, constant throughout the life of the loan.

Index – the variable component of your ARM loan, changes on a monthly basis. Examples of indices include the Cost of Funds (11th District), One Year Treasury, Monthly Treasury Average (MTA), 1 Year Treasury Average, CD, LIBOR, etc.

INDEX + MARGIN = FULLY INDEXED RATE
Example using the 1 Year Treasury: 

1 Year Treasury Index = 6.170
Loan Margin = 2.50
6.170 (Index) + 2.50 (Margin) = 8.67%** (Fully Indexed Rate)

**(most lenders will round the rate to the nearest 1/8%
so the actual rate would be 8.625%)

——————-

Many times ARMs will include low teaser rates and have lifetime caps for interest.

Let’s look at the original article‘s calculations:

On a $200,000 mortgage, the monthly ARM payment at 3.5% would be $898 compared with $1,074 for a 30-year, fixed-rate loan at 5%.

That’s a $10,560 difference after five years, when the ARM would adjust. At that point the ARM rate could jump to a worst-case scenario 8.5% and the monthly payment to $1,538.

It would still take more than 22 months of the higher ARM payments to offset the first five years of savings.

The article takes these numbers a lot lighter than even I would. Jumping from $898 a month to $1538 is nearly a 72% jump in monthly mortgage payments. For many that’s a huge jump for what only looks like a 5% increase in rates. It also assumes that the borrower is saving the difference in payments and will have that money on hand if interest rates rise. That takes incredible discipline and is unfortunately not a realistic behavior to expect from the majority of home buyers.

I believe there are a few assumptions made when it comes to ARMs:

  1. Interest rates will remain low (meaning lower payments)
  2. A home buyer is only going to keep the home for a few years
  3. A home buyer will be able to sell their home before the ARMs start to adjust higher

First of all, right now the interest rates have been at record lows. The federal Reserve has been working hard to keep those rates low, but in the process have created a situation where it cannot be sustained for a long time. Will these rates be this low once an ARM matures? I wouldn’t count on it, but then again that’s my opinion.

Second, how long will it take for the real estate market to recover to the point where a home buyer can sell their home in a reasonable amount of time without taking a large loss? Will it recover in the time before an ARM matures?

The ideas in which ARMs were created from are not new. They are very enticing and the teaser rates are very low. However, beauty is only skin deep, and history has shown that many have been burned.

If you do get into an ARM, make sure you know exactly what you are doing.

Comments
2 Responses to “Is history doomed to repeat itself?”
  1. Cole Voors says:

    Great information Gian! ARM’s can be tricky…people better know exactly what they’re signing up for!

Leave A Comment