Adjustable Rate Mortgage Loans?

[Matthew]

Hi,
I am planning to buy a house of my own and have not been able to decide as to whether to go in for Fixed rate or Variable rate Mortgage. I have also heard of Adjustable Rate Mortgage Loans and would like to study about its suitability considering the other trends of the market. Would someone give me an idea? Thanks!

[ssullivan]

Run! Run as fast as you can from ARMs. Also, given the current turmoil, I'd get a fixed loan. Sure, the Fed will likely be dropping rates soon (so your adjustable might go down), but if there isn't a lot of lending going on in a couple years and the rates go back up, you'll be paying through the nose.

Fixed is the only one that makes sense. The rest are fancy techniques for ripping you off.

[mickmul]

I agree, I'd fix for two years anyway, with an option to extend by three if possible - that way you can go to variable (we don't have Adjustable here, I assume it's the same thing) if interest rates are reduced. Nothing like an (affordable) non changing payment for the first couple of years of a mortgage. Check out the monthly cost of a .5% rate increase on every 100k borrowed . . . we've had 2.5% increase in the last two years. . .

[Tropic Cat]

It depends. If you are planning to stay in the home for many years then a fixed rate 30 year or 40 year is the way to go. If you are planning to move in 2 or 3 years, the adjustable will save you some money.

Under no circumstances entertain an "Option ARM".

[Tspringer]

<sigh> Amazing how folks will post definitive advice on things they know nothing about.


The Fed does not control mortgage interest rates. In the immediate period after the last 2 Fed rate cuts... mortgage rates spiked UP. The Fed sets the discount rate and the overnight lending rates... both of which effect the rates bank borrower from the Fed and from each other. This has a direct impact on "Prime" indexed rates such as home equity lines of credit and credit cards and such but it has no direct impact at all on traditional fixed or adjustable mortgage rates.

Mortgage rates are determined by the price and corresponding yield on mortgage backed securities: bonds. The bond market determines mortgage rates.

All bonds are "Fixed Income Securities". That means you buy the bond and you are guaranteed a set rate of return for the duration of the bond at the end of which you get your original investment back. If you have a 10 year bond that you paid $100 for and it yields 5% then you will earn $5 per year for 10 years at the end of which you get your $100 back. Anyone can go to any securities broker and purchase mortgage backed securities.

Bond prices trade all day long just like stocks. The yield you receive on a bond moves inverse to the price. So as bond prices go UP.. the yield goes DOWN.

Being a fixed income security (the return on your investment once purchased is fixed) how much you will gain in real terms depends on INFLATION. If you are receiving a 5% yield and inflation is running at 2% then you will realize a net gain in purchasing power of 3%. But what if the next year inflation jumps to 4%? Ooooops. Now your net gain is only 1% and the value of your bond (should you want to sell it) will go down. So its inflation and more importantly projections for future inflation that plays the key role in driving bond prices.

Remember: The Fed does NOT control mortgage rates. Inflation is the key factor in how mortgage rates change.

The longer the face value of a bond, the higher the risk. If you hold a 2 year bond then your only concerned with inflation over the short term. Your risk is short term. This also typically means that the price of the bond will be higher than a longer term issue and the yield will be less. A longer term bond, like a 10 year, has higher risk because its far more difficult to predict what inflation may be that far out. So they have a lower price and a higher yield.

When a mortgage lender wants to lend you money... first they must sell bonds and raise the money. The price and yield on these bonds determines the interest rate you will get. **** The spread a mortgage lender gets is relatively consistent across the various bond offerings!!! The short term, lower yield bonds will give the end mortgage borrower a lower interest rate. The longer term, higher yield bonds will give the borrower a longer term fixed interest rate. The margin between the yield the lender must pay out to the bond holder and the interest rate being charged to the end borrower is relatively consistent. The mortgage lender is not making more money on the ARM. The impetus to sell the ARM product is not to "rip you off". It is to give the customer options when evaluating different mortgage scenarios.

(Note: this is not to say that plenty of people have gotten ARM loans over the past 5-6 years who shouldn't have. But the situation is far more complex than "lenders just want to rip you off". )

Rick is right. The key question needs to be how long do you expect to keep the home. If you expect to keep it between 4-7 years then you may be better off with an ARM. A 5/1 ARM is very popular. You get an interest rate that is fixed for the first 5 years of the loan and then converts to being adjustable. When it does convert to being adjustable it will have caps and limits on how much it can adjust and when.

When looking at an ARM.... you need to look at the 10 year trend of the bond index the loan is tied to. Look at the highest indexed rate for the period and calculate the payment you have to pay at that rate. If the payment scares you.... then this program may not be for you.

Seek the best, plan for the worst and work with a professional who is able to explain all of this to you and walk you through a process to make a smart choice.

Right now, the difference in bond yields between short term and longer term bonds is very narrow. This is called a "yield curve" and it is somewhat flat (though not as flat as recent years). This means that the rate advantage you will get with a shorter term adjustable rate is not as large as it has historically been. So I would look very hard at any ARM before making a decision so you properly balance the risks with the rewards.

BTW: I do know a little bit about this stuff as I own a mortgage company.




Terry

[ssullivan]

Well, without writing a book, I do believe I gave the same advice, did I not?

"Stay away from ARMs and forget variable right now."

We didn't need a lesson in macroeconomics to answer the question.


And... I do think that mortgage companies are certainly there to take advantage. So how's business these days? ha ha ha

[Tspringer]

Originally Posted by ssullivan

Well, without writing a book, I do believe I gave the same advice, did I not?

"Stay away from ARMs and forget variable right now."

We didn't need a lesson in macroeconomics to answer the question.


And... I do think that mortgage companies are certainly there to take advantage. So how's business these days? ha ha ha

My point was not to insult you, sorry it came across that way.

I did not advise him to not do an ARM. I advised him to evaluate all available products and compare them to his specific needs and to work with a professional with long term experience in the industry to help make a smart choice.

Mortgage companies exist to make a profit. Its called Capitalism and it tends to work out pretty well. If you view making a profit as "taking advantage"..... well, there are plenty of folks who will agree with you. Karl Marx certainly did.

Business is good. Ive been doing this for 16 years. 50% of my business is referral and repeat clients. This is not the first housing market downturn I have been through and my business was not built on "refi boom".



Terry

Adjustable Rate Mortgage loans work best when you choose a long term loan. However, I would recommend you to visit [link deleted by moderator] where you will be able to find more information on the subject as I found it quite useful when I needed detailed information about Private Mortgage Insurance. Good Luck!

[Tspringer]

PMI is only a factor if putting less than 20% down. Also... most conforming loan programs now offer "lender paid MI". This is where the lender pays an up front one time PMI premium and then increases the interest rate to cover the costs. This will usually result in an overall less payment. You can also do a combo first and second lien to the desired total loan amount and avoid PMI.

I do not like PMI at all... its expensive and there are too many easy ways to avoid it.
It is smart however to really understand what it is and how it all works!


Terry

[Tropic Cat]

Originally Posted by Tspringer

Rick is right. The key question needs to be how long do you expect to keep the home. If you expect to keep it between 4-7 years then you may be better off with an ARM. A 5/1 ARM is very popular. You get an interest rate that is fixed for the first 5 years of the loan and then converts to being adjustable. When it does convert to being adjustable it will have caps and limits on how much it can adjust and when.

I ought to be right. I make my living in this as well... wholesale only.... Terry PM me

[TaoJones]

Originally Posted by Matthew

Hi,
I am planning to buy a house of my own and have not been able to decide as to whether to go in for Fixed rate or Variable rate Mortgage. I have also heard of Adjustable Rate Mortgage Loans and would like to study about its suitability considering the other trends of the market. Would someone give me an idea? Thanks!

Welcome to the Forum, Matthew. It's good to see that someone in their early twenties is thinking ahead and planning for the future. That should serve you well.

Others have given good advice on factors to consider in choosing which mortgage product best fits your situation. But, given the present real estate realities, I suggest that there are three aspects of one fundamental question you must answer before you buy anything - which way are prices heading presently, where will they be when I expect to buy, and where will they be when I expect to sell?

There is an old adage on Wall Street: Don't try to catch a falling knife. It means that if something you might want is falling, it's generally safer to wait until it's hit bottom. You can then pick it up safely.

The same analogy applies to the real estate market. While prices have stopped going up almost everywhere, and are actually going down in many, if not most, markets, most experts in the field agree that the real estate downturn is closer to the beginning than the end.

A lead article in today's LA Times - Homeowners' big question: How low will prices go? - Los Angeles Times - asks "How low will prices go?" That might be something you would want to factor into your analysis of the real estate market. The last I read, there was a 10 to 11 month inventory of actively listed houses overhanging the market. A not-unrelated statistic is, IIRC, that there are seventeen-million owned-but-not-occupied houses in the US.

Many (most?) of the latter are second or third or (?) spec houses that greedy people bought as the market was exploding way back one to five years ago. Arizona and Nevada are full of them, and if prices are declining now, with less than three million houses actively listed, what will happen when those greedy souls throw their "portfolio" into the For Sale inventory (or they lose their properties to foreclosure, and their lenders put them up for sale)

The law of supply and demand in a free market dictates that prices can only go one way to clear that huge overhanging inventory, and re-balance fear and greed.

The inferrence is that real estate prices will continue to decline for the foreseeable future, so whether you choose a mortgage that is fixed or adjustable, or whether you try to sell your new house in two or five or ten years, may not be the most important fundamentals when it comes to entering the real estate market at this time. Once you have a grasp of the price trend in the area where you intend to buy your home, then try to determine how long you will stay there, then choose the best loan product for you at that time.

As you make the effort to determine when/where/how you will begin your real estate investing, try to educate yourself on the historical cycles in the US real estate market. It would be a mistake to assume that the period from about 1999 through 2005 or 2006 is representative of what real estate can be expected to do all of the time - or even most of the time. That period (from the time you were about 15 to 21 or 22) was an anomaly, and only representative of a bubble created by loose lending standards and reckless creation of excessive credit and money supply.

You may very well know someone, or even several people, who made (nominal) fortunes in real estate during that period. One or more of them may be encouraging you to take the plunge with lame aphorisms like "Real estate always goes up!" or "Buy land - they aren't making any more of it!" or - well, you get the idea.

I hope the foregoing doesn't strike you as depressingly negative - that certainly isn't my intent. I'm only trying to encourage you to carefully analyze American real estate investing in the current era in detail before you sign anything.

Good luck to you in your quest.

TaoJones

[David M]

Well stated Terry. I don't think I have ever heard a clearer and concise explanation. The Karl Marx comment was hilarious and made the point.

[GordMay]

Originally Posted by ssullivan

Well, without writing a book, I do believe I gave the same advice, did I not?...
... We didn't need a lesson in macroeconomics to answer the question.

Many queries could simply be answered “yes”, “no”, or (perhaps) “33.3”.
The “book” that some may attach to their answers, tends to qualify the responder. As often as not, the “why” may be as important as the “what”.

[cnj]

I've been in the mortgage industry for 18 years and here's my thoughts...

If you're getting an ARM... Keep in mind the first rate you get is a "discounted" rate which means, most likely, no matter what the market does, the rate will go up on the first change date. If you do get an ARM, go with 3 years or longer (ie 3 years before the rate changes), which also gives you 3 years to refinance. Some loans also have a provision that you can change them to a fixed loan without going through the whole loan process again (conversion option). Stay away from neg ams (negative amoritization) loans, with these, the payment doesn't cover the cost of the loan, so you end up owing more then when you started. I agree that if you're not planning on staying in the house long, an ARM might work for you. Also keep in mind (most importantly), that in most states (NY being an exception, and 2 others that I can't think of off the top of my head), your ability to pay the loan is based on this lower rate and if the rate goes up, you may not be able to afford it.

[marty9876]

Thanks for the posts guys! At the end of the day a 5/1 ARM was close to the only way I was getting into my first house a few years back. Not the best method, but it's worked well so far.