San Diego Mortgage Advice: Call to ARMs

Adjustable rate mortgages, ARMs for short, are the most misunderstood, misused, and maligned financial instrument.  The have been abused by consumers, Realtors and loan originators alike these past 3-4 years and are now the subject of national scourge.  Much like our Second Constitutional Amendment critics, the ARM critics are usually misinformed and preying upon the fear of catastrophe. 

These inexperienced mortgage sales people or "loan hacks" as I like to call them, are banking upon your fear of catastrophe.  Loan hacks sold you ARMs in 2003 and negative amortization ARMs in 2005.  After they ride the fixed rate mortgage trend, they'll move on to reverse mortgages. They lack original thought and critical analysis.  They'll sell you any loan that is on the front page of USA Today.

ARMs don't cause foreclosures, loan hacks cause foreclosures.

READ:   I am an American ARMs dealer.

Fixed rate mortgages, for the lion's share of the population, are an inappropriate recommendation.  Mortgage advertisers, unschooled in financial planning , are aggressively advertising fixed rate mortgages as a cure to the rising ARM rates.   They're encouraging you to sell low and buy high.

SAY WHAT?   DID THEY FORGET THAT RATES GO DOWN, TOO?

You should lock in a fixed rate mortgage at the low end of an interest rate cycle, not the high end of it.  It is easier to sell fear than to properly counsel you so these loan hacks will try to baffle you with slick sounding "Myths". 

 

Three Myths Fixed Rate Loan Hacks Love to "Quote":

1- Fixed rate mortgages are the safest loan out there-  Categorically incorrect.  Annual ARMs outperform fixed rate loans over any given five year period and have since World War Two.

2- The inverted yield curve rewards fixed rate mortgages today- An inverted yield curve is when short-term interest rates are higher than long-term interest rates.  Indeed, ARM rates and fixed rates will appear identical.  It would appear rational, to the unknowing eye, to "lock-in" to a fixed rate mortgage.  Here is what the loan hacks omit; an inverted yield curve has preceded an economic recession, over 85% of the time, since the Civil War.  Recessions lead to lower short-term rates which would save you thousands of dollars in the near future.  It is better to lock-in a fixed rate at the low end of an interest rate cycle.

3- We are still experiencing historically low interest rates- Again, another myth. Mortgage rates, historically, fluctuate between 5.5% and 6.5%.  The average homeowner, however, doesn't realize that because of the aberration of the 1975-1989 period.  We all remember the high mortgage rates of twenty years ago and make financial decisions while looking in the NEAR TERM rear view mirror.  That's our perspective.  We need  a longer-term perspective to understand that rates of 5-6% were the norm, not the exception. Ask your parents or grandparents about their mortgage rates.

How should a potential homeowner select an ARM?

1- Qualify for the mortgage at 2% above the adjustable rate.  If you are selecting an ARM to "get into" the home, you should be renting.

2- Invest the difference between the starting mortgage rate and the 2% higher mortgage rate into a short-term, liquid side fund.  Liquidity solves problems with a change in financial status.  If you are applying for a $300,000 loan, get a 5.5% ARM and invest $500 month into a liquid investment.  If your rate rises 1%, next year, lower your investment to $250/month.  If your rate rises 2%, discontinue the investment fund, temporarily, until the rate lowers again.  If, for some strange reason, your rate rises a full 3%, subsidize your payment with the funds from your earlier savings.

3- Understand that interest rates move in 3-5 year cycles. We are currently in the third year of this cycle.  It is possible that we have reached the peak in mortgage rates.  If rates start subsiding, and a fixed rate mortgage can be had for 5.5% or better, refinance and lock-in a fixed rate mortgage if you plan on owning the property for more than 3-5 years.

4- Explore and make use of hybrid ARMs if you are undisciplined.  If you feel that you'll fritter away your cash flow savings rather than invest it, lock in a rate for 3-7 years. It's not as good as an annual ARM but it will still save you a bit of money.  If you are undisciplined at saving money, you ought to consider renting as an alternative.

Homeownership requires liquidity.  If you intend to sink every bit of extra cash into a home, stay healthy, don't get divorced, and don't die.  Disability, Divorce, and Death are the three leading causes of foreclosure.  Combine one of those catastrophic events with no liquidity and you are a foreclosure waiting to happen.

5- Finally, never, never, NEVER, take out an ARM with a margin of more than 3%. A margin is the "markup" to the index that determines your interest rate.  It's the lender's profit.  They borrow the money at the index and lend it to you at index plus margin.  You'll have a difficult time finding a margin below 2.5%.  Some do exist at 1% margins for large loan amounts.  Call me for details.  If you have to get a loan with a higher margin to "get into the property", don't buy the property.  You simply can't afford it.

CONCLUSION:

ARMs don't kill people, loan hacks do.  Find an experienced, educated mortgage adviser, with financial planning training, to assist you with your loan.  If you think that dealing with a professional is expensive, wait until you see how much an amateur can cost you.

This article was selected as the best post of all the carnival contests

This article was selected as a winner in the 52nd edition of The Carnival of Real Estate

Comments

[Sacramento Real Estate]

Brian,
Excellent article. Sometimes Mortgage and Loan information can be confusing and hard to understand but you simplified it. This is truly a help to the average Home Buyer and Homeowner that is considering buying and/or refinancing.

Love to have you write an article like this as a guest on Sacramento Real Estate Voice.

- Gena Riede

[Roberta Murphy]

Brian: Excellent article and a natural winner.

Those "loan hacks" to which you refer have done an enormous disservice to all. And as we have discussed, licensing for mortgage originators should require far more education and a higher bar for entry.

Additionally, I believe real estate agents should be prohibited from originating loans--and vice versa. Clients deserve objective and independent counsel from both their Realtor and their mortgage professional.

[Brian Brady]

Thanks to both of you, Gena and Roberta.

The libertarian in me believes that originator licensing and excluding Realtors from originations could potentially inflate loan fees to the consumer. The pragmatist understands the need for, as you so eloquently put, Roberta, "objective and independent counsel" from both disciplines.

I'd err on the libertarian side of me with hopes that education would cause the consumer to realize that the largest financial transaction, for most of them, requires that independent and objective counsel.

Thank you both for your comments

[Toby & Sadie]

Cograts on the great post - and the honors that have come with it - Mr. Brady! You do a great job of explaining a very complex and "scary" topic.

[Tom Armstrong]

Brian,

Excellent food for thought... Thanks for the kind words on my blog!

Best,

Tom

[Brian Brady]

An interesting read, Mike.

I'll stick with Alan Greenspan's numbers, though.