The ARM sales pitch

My eyes have been poked through many inexpensive items in recent years. There was no shortage of views that the main economic engine keeping the United States from suffering a lasting recession, if not a depression, is the ability of homeowners to extract capital from their homes and then spend it on consumer goods.

I’m not going to get into a discussion about whether or not this opinion has merit. What I would like to discuss is how such a transaction (the refinance mortgage, and in particular the adjustable rate refinance) is presented to the homeowner. Just for the reader’s information, my experience in this area is based on closing over 750 of these transactions in the last 4 years, most of which involved Adjustable Rate Mortgages (ARMs).

An ARM pays off the principal and a fixed interest rate only for a period of years, typically two to five. After the initial term, the interest rate fluctuates with the then prevailing rate. The selling point of this type of loan is a lower interest rate than a traditional 30-year fixed-rate mortgage. In some cases, the payment can be several hundred dollars a month cheaper. Of course, the borrower is concerned that rates are trending higher and wonders if this is a good idea. The mortgage broker “solves” this problem, as he explains to his client, “in six months, your credit will be better and we can lock in a lower fixed rate at that time.”

I witnessed countless cases where this pitch worked with subprime borrowers. I decided that for this article, I would break it down into dollars and cents because I believe numbers don’t lie.

So I ran the numbers using the current rates found on bankrate.com. I’m not entirely sure you can get a 6.15% APR for a 30-year fixed mortgage, but since this is just an illustration, let’s just imagine, shall we?

Now the first 24 months (2 years) of a 30-year fixed is amortized (monthly) as follows:

$200,000 @ 6.15%

Interest Payment Principal Balance

9/2/2006 1,218.46 1,025.00 193.46 199,806.54

2/10/2006 1,218.46 1,024.01 194.45 199,612.10

2/11/2006 1,218.46 1,023.01 195.44 199,416.65

2/12/2006 1,218.46 1,022.01 196.45 199,220.21

1/2/2007 1,218.46 1,021.00 197.45 199,022.75

2/2/2007 1,218.46 1,019.99 198.46 198,824.29

3/2/2007 1,218.46 1,018.97 199.48 198,624.81

4/2/2007 1,218.46 1,017.95 200.50 198,424.30

05/02/2007 1,218.46 1,016.92 201.53 198,222.77

2/6/2007 1,218.46 1,015.89 202.56 198,020.21

2/7/2007 1,218.46 1,014.85 203.60 197,816.60

2/8/2007 1,218.46 1,013.81 204.65 197,611.96

9/2/2007 1,218.46 1,012.76 205.70 197,406.26

2/10/2007 1,218.46 1,011.71 206.75 197,199.51

2/11/2007 1,218.46 1,010.65 207.81 196,991.70

2/12/2007 1,218.46 1,009.58 208.87 196,782.83

01/02/2008 1,218.46 1,008.51 209.94 196,572.89

2/2/2008 1,218.46 1,007.44 211.02 196,361.87

3/2/2008 1,218.46 1,006.35 212.10 196,149.76

04/02/2008 1,218.46 1,005.27 213.19 195,936.57

05/02/2008 1,218.46 1,004.17 214.28 195,722.29

2/6/2008 1,218.46 1,003.08 215.38 195,506.91

2/7/2008 1,218.46 1,001.97 216.48 195,290.43

08/02/2008 1,218.46 1,000.86 217.59 195,072.84

And a 5-year ARM amortizes over the first 24 months as:

$200,000 @ 5.82%

Interest Payment Principal Balance

09/02/2006 1,176.05 970.00 206.05 199,793.95

2/10/2006 1,176.05 969.00 207.05 199,586.89

2/11/2006 1,176.05 968.00 208.06 199,378.83

2/12/2006 1,176.05 966.99 209.07 199,169.77

01/02/2007 1,176.05 965.97 210.08 198,959.69

2/2/2007 1,176.05 964.95 211.10 198,748.58

03/02/2007 1,176.05 963.93 212.12 198,536.46

04/02/2007 1,176.05 962.90 213.15 198,323.31

05/02/2007 1,176.05 961.87 214.19 198,109.12

06/02/2007 1,176.05 960.83 215.23 197,893.90

2/7/2007 1,176.05 959.79 216.27 197,677.63

08/02/2007 1,176.05 958.74 217.32 197,460.31

09/02/2007 1,176.05 957.68 218.37 197,241.94

2/10/2007 1,176.05 956.62 219.43 197,022.51

2/11/2007 1,176.05 955.56 220.50 196,802.01

02/12/2007 1,176.05 954.49 221.56 196,580.45

01/02/2008 1,176.05 953.42 222.64 196,357.81

2/2/2008 1,176.05 952.34 223.72 196,134.09

03/02/2008 1,176.05 951.25 224.80 195,909.28

04/02/2008 1,176.05 950.16 225.89 195,683.39

2/5/2008 1,176.05 949.06 226.99 195,456.40

06/02/2008 1,176.05 947.96 228.09 195,228.31

2/7/2008 1,176.05 946.86 229.20 194,999.11

08/02/2008 1,176.05 945.75 230.31 194,768.80

There you have it – two amortizations for 24 months. Remember, the sales pitch states that the borrower will repair his credit in two years (sometimes as soon as 6 months), at which time he can lock in a lower fixed rate for 30 years.

It appears that the borrower saves the difference in the monthly payment ($1,218.46 – $1,176.05 = $42.41) multiplied by 2 years or 24 months (24 * $42.41 = $1,017.84). Keep in mind that the rate difference is 33 basis points or 1/3 of a percent. In some transactions, such as with subprime borrowers, the difference can be as much as 3/4 of a percent. For the purposes of our illustration, the borrower gets a lower monthly payment of approximately $43, which equates to a savings of just over $1,000 over two years. So the question arises, is it worth it? To find out, let’s take the analysis a little further.

rate forecast

Forecasting future interest rates is quite difficult. I don’t think I would have much disagreement with that statement. However, considering the current trend and historical averages, we may be able to forecast slightly higher rates in the next two years. If this is the case, how can the borrower be sure that their payment will decrease once their credit score improves? Sure, his score might qualify him for a lower rate, but the borrower isn’t sure how much lower. Could the rate on a 30-year fixed mortgage be higher in two years than the adjustable rate on the closing date? It’s certainly possible, isn’t it? In my opinion, the borrower cannot be sure if their future fixed rate will be lower in the future. The strategy, at first glance, fails because it is based on predicting variables (interest rates and credit scores) that are virtually unpredictable in the future.

Closing Costs Conveniently Skipped

But if we dig even deeper, we can see more clearly the folly of this strategy. Below are typical closing costs associated with a residential refinance loan. This list is not exhaustive, but is offered only to give the reader an idea of ​​how much a loan with a $200,000 home loan might cost an unsuspecting borrower.

* Application fee $450

* Loan origination fee 2% or $6,000

* Tax Service Fee $70

* $10 Flood Certification Fee

* Closing fee $475

* Title Policy $1,100

* Recording Fee $350

* Overnight and email $90

* Appraisal $300

$8,845

If the borrower actually refinances their ARM in two years, they will have to pay these same closing costs again. Virtually none of these can be avoided unless you have a friend who is a lender. The costs outweigh the dollar-for-dollar monthly payment savings by more than 8 to 1. What a deal! Remember, this calculation doesn’t even consider the time value of money or the opportunity cost of interest paid.

Meanwhile, if you look at the amortizations again, you’ll see that virtually none of the principal is paid after two years. (For more on this situation, read my article An Interesting Look, written several weeks ago.) What this means is that the borrower must start the process all over again, paying almost all of the interest for the first few years and practically none of the principal. In effect, the borrower has been renting the house from him for two years, the bank as owner. After all, it is the American way.

Of course, a mortgage banker would probably take umbrage at this analysis and would probably offer the following rebuttal: an honest banker (trying not to laugh) would make sure the product/loan fits the borrower’s needs. For example, a good loan officer would ask if the borrower plans to stay in the house or if he expects to move in a few years. If he stays in place for 30 years, the savings and “peace of mind” far outweigh closing costs.

But this is a terribly big “if.” And since the borrower misplaced his crystal ball, he usually nods and says that he has nowhere to go. But the “honest” banker knows that the vast majority of people move within 5 years and virtually no one pays their mortgage in full.

The real problem is that people trust these bankers to get a good “rate” which the borrower believes is the crux of the problem. The real problem is the amount of the loan. The fee is simply the smokescreen bankers use to separate their clients from their money, over and over again. I see closing costs over $10,000 on these deals time and time again. But the borrower hardly ever asks for them. All he cares about is the rate and payment. If the figure is within his budget, he signs the papers. It’s as simple as that. A simple look at what it costs clears the fog, but very few bother to do so.

I guess they believe that the price of real estate will always go up and that costs are simply what you have to pay to play the real estate market. Essentially, a homeowner takes a position in an asset on the open market just like a trader takes a position in the futures or stock markets. But real estate is often a highly leveraged asset in an illiquid market. Both of these features of the residential real estate market pose significant risks for owners of this asset class.

Of course, maybe they are right. Maybe this time it will be different.

Thank you for your time.