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“In Arm’s Way: The Tender Trap of Adjustable Rate Mortgages.”

“In Arm’s Way: The Tender Trap of Adjustable Rate Mortgages.”

Contrary to popular rhetoric,
given today’s interest rate environment there are no circumstances for which
homebuyers should choose adjustable rate mortgages (ARM’s). That so many
are currently opting for ARM’s reflects a level of real estate speculation
unparalleled in American history. Homebuyers have been lured into this foolish
choice by real estate and mortgage brokers eager to earn commissions, their
own avarice in pursuit of easy riches, and by a fed chairman desperate to
keep the real estate bubble inflating. Unfortunately, the longer the Fed
remains “patient” with regard to raising short-term interest rates
to appropriate levels, the more homeowners that will be lured into the ARM
time bomb.

One argument is that by
using ARM’s, “savvy” homeowners save money because even when interest
rates ultimately rise, the months of lower payments will more than offset
the extra months when the payments are higher. This ignores the fact that
when those higher payments ultimately arrive most borrowers may not be able
to afford to make them. After all, it is not as if they are saving the money
that otherwise would have been spent on higher fixed-rate mortgage payments,
to be drawn upon to meet future increases in ARM payments. The typical borrower
is already maxed out with the current low payment, and hopes to meet any
higher future payments by extracting appreciated equity.

The most popular justification
for choosing an ARM (other then the fact that many borrowers simply can not
qualify for a fixed rate,) is the buyer’s intention to sell the house in
a short period of time, say 2 -3 years. The rationale follows that if buyers
will be selling their houses in 2-3 years, why pay the higher interest costs
of a 30 year fixed-rate mortgage?

First of all, the fact
that people buy houses with the intention of selling in 2-3 years is itself
one of the best signs of the speculative nature of the current real estate
market, for those doing so are speculating on price appreciation, plain and
simple. Without such an expectation, such individuals would be far better
off renting, especially given today’s high housing prices, transaction costs,
and relatively low rents. One of the main arguments against renting is that
renters “throw away money on rent.” Forgetting for a moment that
one no more “throws away money on rent” than one does on food,
clothing, or any of life’s necessities, individuals buying and selling
houses in 2-3 years (since no payments of principal are made) are throwing
away money on interest, real estate commissions, loan and closing costs,
taxes, insurance, maintenance, and moving expenses. Therefore, not only should
individuals planning on selling their houses in 2-3 not use ARM’s, they should
not even be taking out mortgages at all— they should be renting! That
is unless they are speculating that the property will appreciate to a degree
higher than all of those costs.

Short term buyers could
have only two possible plans; sell and rent, or sell and buy another house.
The only reason to buy a house, with the ultimate intention of selling in
a year or two to become a renter, is to speculate on price appreciation.
However, if you listen to real estate brokers, most are planning to sell
current purchases in 2 -3 so that they can trade-up for houses more expensive
than the ones they can currently “afford.” The money to buy these
more expensive houses (which, if the desired scenario pans out, will become
even more expensive) will come from the equity accumulated in the “starter” homes.
In other words, in these situations, buyers are also speculating on price
appreciation.

Assuming today’s short-term
buyers put their houses on the market 2 -3 years from now, to whom will they
sell, especially if interest rates have risen sharply? If the current crop
of buyers relied on low interest ARM’s and lax lending standards to qualify
for their mortgages, how will future similarly situated buyers qualify with
higher interest rates and stricter lending standards? And if the current
short-term buyers can not sell their houses, how will they afford to move?
Even if they could sell, how would they be able to afford the increased payments
on more expensive houses in a much higher interest rate environment? Therefore,
short-term buyers may very well end up living in their houses for much longer
periods of time then was their intention, unless of course, as will be the
case for most, they lose their houses in foreclosure, in which case they
become renters.

Buying a house used to
represent a long-term commitment to paying off a mortgage, a place to raise
children and to grow old. This concept is completely lost in today’s world
of short term ARM’s and interest-only mortgages, which defeats equity accumulation,
traditionally the main advantage of homeownership. Real equity is accumulated
by paying down a mortgage. However, in today’s real estate bubble, principle
payments are rarely made, and homeowner are convinced that equity accumulates
though price appreciation alone. In the perverse world of “starter homes” and “trading
up,” homebuyers accumulate greater and greater amounts of debt. Instead
of reaching retirement age with fully paid for homes, a situation often critical
to making retirement possible, today’s homeowners will be in debt up to their
eyeballs. Sure, they will supposedly have all this equity accumulated from
price appreciation (assuming it hasn’t been tapped into through cash-out
refi’s) but will that equity really exist when homeowners need to sell?

Those who argue that real
estate is not a bubble typically have a vested interest in perpetuating it.
The biggest boosters have been those that make their living in the real estate
industry (or in one of the many industries it supports), or those that own
real estate, and whose judgments have therefore been clouded by their own
greed. Those arguing that rising interest rates will not affect home prices
are living in some self-serving, delusional, alternate reality. Pundits who
point to the fact that rising interest rates in the 1970’s did not lead to
significant price declines in real estate are comparing apples to oranges.
They fail to take into account the proliferation of adjustable rate mortgages,
the fact that so much of the “equity” accumulated during the bubble
has already been cashed out, and other economic variables, such as the fiscal
and current account imbalances, and the high debt levels and low savings
rates so prevalent in the highly leveraged, de-industrialized, modern American
economy.

The real losers in this
whole fiasco are likely to be those who did not even participate in the mania.
It will be American savers, who’s retirement dreams will vanish in a cloud
of hyper-inflation. As over-leveraged borrowers walk away from properties
in which they have no equity, the Fed will most likely attempt to bail out
both debtors and bank depositors (and the government sponsored enterprises
that insured the loans) with the most inflationary monetary policy ever undertaken
in the history of central banking. The savings of an entire generation will
be wiped out, as it will have been squandered to perpetuate the biggest real
estate and consumer debt bubbles of all time.

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