Economist's Commentary: April 28, 2008
When an ARM Makes Sense
By Ken Fears, Manager, Regional Economics
The recent surge in foreclosures makes one wonder why anyone would ever have used an adjustable rate mortgage (ARM). These mortgage vehicles have risk, are confusing, and most people don't understand their sophisticated nature. These points may be true, but there are times when it makes sense to use one.
During a speech in late February of 2003, Alan Greenspan commented on how high long-term mortgage rates are in the United States relative to rates on ARM. He pointed out that it is more common for home buyers in Europe and Latin America to use ARMs. Greenspan credited this phenomenon to greater risk aversion by US home buyers. He then suggested that the audience members, executives from the nations' credit union industry, should do more to create alternative mortgage vehicles to the traditional fixed-rates. Some pundits have pounced on this speech as an example of how Greenspan helped to create the problems in mortgage market that led to the rise in foreclosures and the subsequent credit crisis.
In the speech, Chairman Greenspan pointed out that the difference between ARM and FRM rates is large. He also suggested that the fees that borrowers must pay to refinance are too high. He then posited that borrowers would have saved substantial amounts of money had they used ARM loans rather than FRM loans in the 1990s as mortgage rates fell. However, he is quick to point out that rates could have risen over this period and that borrowers using this vehicle must be "willing to manage their own interest rate risk".
What was Mr. Greenspan getting at? As suggested by the graph above from Bankrate.com, the average 30-year FRM was roughly 120 basis points higher than the average 5/1 ARM in March of 2003. This spread computes to an initial monthly payment of $691 using a 5/1 ARM for a home priced at $180,900 , $104 less than that for a 30-year fixed. The total savings over the initial five-year portion of the loan would have been $6,225. This savings only increases with the size of the loan. Given that the average tenure of a home is only 6 years , then a homebuyer looking to live in their home for 5 years could use a 5/1 ARM. Likewise, a homebuyer with a 7 year time horizon could use a 7/1 ARM. The savings could then have been used to pay down principle, to make improvements to the home, or refinance into a fixed rate mortgage.
While many of the recently foreclosure properties used ARMs, these loans were significantly different than those the chairman was suggesting. First, the loan of choice in 2005 was a 2/28, interest only loan, which had very low, introductory monthly payments which nearly doubled after the reset. Second, the mortgage writing industry significantly relaxed its standards for borrowers' income and risk over this period, an irrational and irresponsible move that the Chairman neither suggested nor could not have anticipated in 2003. Next, mortgage rates had been forecast to rise for some time by 2005. This fact suggests that borrowers either did not have the ability to bare the interest rate risk or that they were mislead into believing that they could. Finally, in 2003 there was still room for prices to safely grow before reaching the questionable period in 2005. This equity would be intact today and could facilitate refinancing.
Despite the fact that ARMs are at the center of the current foreclosure problem, Chairman Greenspan's suggestion in 2003 that borrowers could have saved significant sums of money using this mortgage vehicle is still valid. Today, the spread between ARMs and fixed rate mortgages has tightened dramatically and the risk of rising mortgage rates is high. Consequently, using an ARM would not be prudent. However, a responsible borrower with sound understanding, appreciation, planning for mortgage rate risk could have saved significant sums versus a fixed rate mortgage in 2003 as well as the during the preceding decade.
[1] This calculation is based on the median U.S. home price for March of 2003. It assumes a 20% down payment, a 4.0 percent 5/1 rate, a 5.2 percent 30-year fixed rate, and no re-investment of the monthly savings. Also, no pre-payment penalty is assumed (e.g. prime) for the ARM loan.
[2] National Association of Realtors, Profile of Home Buyers and Sellers. 2007. p. 78
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