Why It Makes Sense To Stay Away From Today’s ARMs

by Peter G. Miller
March 16th, 2009

Freddie Mac reports that you could get a 30-year fixed-rate loan last week at 5.03 percent with .7 points. Since that’s an average, you have to figure that some people are actually borrowing at less than 5 percent.

Meanwhile, you could also get an adjustable-rate loan at 4.80 percent with just .5 points.

The adjustable is plainly cheaper — it’s also a lousy deal.

Usually price-conscious folks are advocates of low-priced goods and services. We shop for bargains, compare prices online and we test and fidget until we can find the lowest possible cost.

But low cost is not always what we want. The classic example concerns hamburger. Imagine that a store sells “hamburger” for $2 a pound and that it also sells “unclean hamburger” for $1 a pound. Even with a huge discount not too many people will pull from bin #2.

In a similar sense, fixed-rate and adjustable-rate loans are both “mortgages” but they’re not the same product even when principal balances are the same.

___ An ARM typically has a lower rate than a fixed-rate loan. The bigger the gap between the two products the better the ARM.

___ An ARM typically has easier qualifying standards, what lenders call front and back ratios. With an ARM perhaps as much as 31 percent of your income can be devoted to housing costs versus 28 percent for a conventional fixed-rate loan. These “front ratios” mean that for a given level of income you can borrow much more with an ARM.

Why do lenders offer ARMs with lower rates and easier qualifying standards? Ah, let me explain, said the spider to the fly….

Lenders want borrowers to be on the hook for inflation. In other words, if mortgage rates go up in the future then borrowers with fixed-rate loans will have a hedge against such higher costs — and lenders wont.

Lenders, of course, greatly prefer the reverse situation, where if rates rise so will mortgage interest levels.

So, to get borrowers interested in a more-risky loan product — and that’s exactly what an ARM is — lenders shine their lures, practice their pitch and encourage folks to borrow more, something quite possible with an ARM.

You can get FHA mortgages as either fixed-rate financing or in an adjustable format. If you really and truly want an ARM, then you want the FHA loan with its strong caps and lack of gotcha clauses and prepayment penalties.

But are higher rates and inflation really a worry?

You bet.

First, rates today are about as low as rates have been at any time in the past 50 years. The odds of them going substantially lower — one reason to get an ARM — are incredibly long and implausible.

Second, the government is racking up debt at an incredible rate. The issue is not whether such debt is or is not necessary to re-start the economy, instead the issue is that government debt is growing, debt which can lead to a devaluation of the dollar and less spending power. In other words, debt is one factor that impacts the potential for inflation.

Third, massive imbalances with foreign trading partners, another factor that contributes to inflation, are down recently, but the accumulated total of foreign debt continues to grow and is vast. China, as one example, owns on the order of $1 trillion in U.S. debt.

Given these factors, if you want FHA financing then it’s likely best to stick with plain, vanilla fixed-rate loans. They’re not as exciting as ARMs, but then that’s a quality which should be welcomed.

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