Lay Off The ARM's
A: I don't link to David's site BubbleMeter too much as I think his bias towards the housing bubble clouds the content a bit on the site; although I do think it is a very good read! Today, he has a post concerning ARM's, or Adjustable Rate Mortgages, as the federal reserve just issued a 37-page brochure in an attempt to educate homebuyers of the pitfalls of using an ARM loan product; especially if you choose an ARM to rationalize buying a house that is OVER YOUR BUDGET!
What is an ARM (Adjustable Rate Mortgage): An adjustable-rate mortgage differs from a fixed-rate mortgage in many ways. With a fixed-rate mortgage, the interest rate stays the same during the life of the loan. With an ARM, the interest rate changes periodically, usually in relation to an index, and payments may go up or down accordingly.
Lenders generally charge lower initial interest rates for ARMs than for fixed-rate mortgages. At first, this makes the ARM easier on your pocketbook than a fixed-rate mortgage for the same loan amount. Moreover, your ARM could be less expensive over a long period than a fixed-rate mortgage--for example, if interest rates remain steady or move lower.
Against these advantages, you have to weigh the risk that an increase in interest rates would lead to higher monthly payments in the future. It's a trade-off--you get a lower initial rate with an ARM in exchange for assuming more risk over the long run.
Federal Reserve Consumer Handbook on ARM's
Some important points of this handbook include:
UrbanDigs Says: NEVER, EVER, EVER consider taking out a ARM product because you need the lower monthly payment to afford the home you are thinking about buying. If you do, that means you are buying a house you can NOT afford and rationalizing the purchase by taking out a riskier loan product. Not a good way to go about a generally wise investment.
Rather, if you are 100% certain you will be selling your home within a short period of time than a ARM product makes sense. And even in this case, you should take out an extra 2 years on the ARM product just to cover yourself in case plans change over time. For example, if you know you will be selling in 3 years or less, take out a 5 YEAR ARM; if its 5 years or less take out a 7 YEAR ARM! Otherwise, the small difference in monthly payments makes a 30 YR fixed product a wiser choice. If you are considering an interest only loan, reconsider your entire budget and reason for buying in the first place! One of the best aspects of owning your own home is that you are forced to save by paying down a little bit of principal each month, giving you more equity in your home.
Comments (2)
One might ask why the Federal Reserve is becoming involved in a private decision. I suspect that one reason is that it impacts their Monetary Policies. When the economy is in danger of over-heating, the goverment will want to raise interest rates (conversely, it lowers them when the economy is in danger of recession). However, if a significant portion of the population has ARMs, the goverment's ability to use monetary policy to cool an over-heating economy is constrained by the fact that interest rate rises will cause financial difficulties and perhaps foreclosures for many home owners (which is to say, potential voters). It is in the goverment's interest to minimise this risk by discouraging ARMs.
Posted by Robert (property agent) | January 4, 2007 5:43 AM
Robert - Good Points...Mainly, its in the govt's interest to get involved if they feel the public is being skewed or tricked into riskier loan options by lenders when otherwise they would never be approved for a loan in the first place. Now that housing is clearly cooling and risks are more to the downside fundamentally, the fed is getting involved to limit the use of riskier loans, such as I/O ARMS, by education.
Whether their call gets heard is an entirely different story.
As for monetary policy, the housing effect is unfortuntaley NOT the main concern in the eyes of the fed. Certainly it is on their radar and they dont want to cause any kind of catastraphe in housing, but primarily, they want to ease inflation pressures by slowing the economy and control pricing stability. If inflation got out of hand, the fed would be FORCED to raise monetary policy alot more than they want and that affect is far worse then where they are now.
Posted by Noah | January 6, 2007 8:53 AM