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With the recent credit crunch, commentators
have rushed to blame whomever they can find: borrowers, lenders, the Federal
Reserve -- anyone who deals in dollars.
But perhaps no one has taken more blame
than those lenders who dealt in adjustable-rate mortgages (ARMs).
Some media coverage has even suggested that if it weren't for ARMs, the
market would still be booming.
Yes, there
have been problems. A few disreputable lenders extended credit beyond their
borrowers' ability to repay their loans. Some borrowers deceived themselves
into buying more home than they could afford. Income and assets weren't
verified. And credit was extended where it should not have been. Often, it
was a combination of these factors.
But the key point is the problem wasn't
with adjustable-rate mortgages, per se. Rather, it was with some ARMs and
some lenders. The same problems are found with car loans, for
example. In some cases, a sweet-talking salesman will sell a buyer with
marginal credit a loan that will likely pummel him with steep interest-rate
payments and leave him owing more on the car than it's worth. Such a buyer
is likely to default and it would be wrong to sell him such a loan in the
first place. But that doesn't mean that all car loans are bad or that all
finance companies are disreputable.
Adjustable-rate mortgages are no
different. They were created to give
today's homebuyers greater flexibility in an economy that is increasingly
fluid. People move much more often than they used to; the typical American
family stays in a home for about five to seven years. For many of
these families, a traditional fixed-rate, 30-year mortgage doesn't make
sense, because the period of actual homeownership is so short.
Conventional fixed-rate loans offer long-term predictability -- the
homeowner knows what his monthly payment will be next month and what it will
be 15 years from now.
An ARM
might be a better option for a young family that will likely relocate to
another city within five years, perhaps as a result of a promotion or job
transfer. ARMs can also be a great deal for
older buyers for whom a commitment of three decades just isn't realistic. In
both situations, buying into a rigid, 30-year commitment may not be the best
option.
Why is it that some lenders only offer
consumers a 30-year guaranteed loan, when that product both costs more and
simply is not needed? With an ARM, monthly payments can be structured
to take advantage of interest rates right now -- not 15 years down the road.
The result?
Families spend less money on their monthly mortgage payment during the
period that they are actually in the house -- and thus have more cash each
month for other needs. And when the time comes to move, they'll come out in
much better shape than they might have with a traditional loan structured
for a long-term commitment.
Consider a
mortgage of $225,000 -- the approximate cost of the typical new-construction
single-family home. Assuming the mortgage has a 30-year fixed rate of 6.75%,
one would pay $87,540 over five years. If instead, one had an ARM and a rate
of 6.125%, that person would pay just $82,020 over five years.
In other words, long-term payment stability
comes with a price tag of $1,100 each year. So it's the 30-year fixed
mortgage that gives consumers the short end of the stick.
If, after
five years, a borrower employing an ARM doesn't move, he can either
refinance or accept the reset rate. Refinancing, of course, often allows the
borrower to take advantage of a lower interest rate, which can reduce
monthly payments and the overall cost of the mortgage. What's more, it
allows the borrower to reduce the term of his loan, cutting his total cost
and enabling him to build home equity more quickly than he would otherwise.
And when it
comes to the current bogeyman, the reset rate, it turns out that most
highly-regarded lenders offer extremely reasonable resets. It's only the
mortgages that were offered by subprime lenders that reset (and are still
resetting) at unaffordable rates. These lenders enticed buyers through
incredible introductory offers. And buyers, banking on pay raises and
continued bullishness in the economy, willingly signed, despite the fact
that some of these subprime loans reset at rates comparable to those on
high-interest credit cards.
The bottom line is that any lending tool --
whether it's a bar tab or a bank loan -- can be abused. But just as we
shouldn't get rid of bar tabs, ARMs are worth keeping around. When used
responsibly, adjustable-rate mortgages can be a financially sound and
cost-effective way for modern families to purchase a home.
