Adjustable rate mortgages

by John Quiggin on February 26, 2005

A striking development in the US economy in the last few years has been the growth in adjustable rate mortgages. This raises a couple of questions. First, if you’re thinking about buying a house, is better to go for adjustable or fixed-rate? Second, what does this mean for the economy as a whole?

CT doesn’t offer personal finance advice (as yet), but I will point out that the fixed-rate mortgages on offer in the US are a much better deal than those in Australia (and, I think, elsewhere). In a standard comparison of fixed and adjustable rates, the fixed-rate contract is good for the borrower if interest rates go up, and bad if interest rates go down. The opposite is true for the lender.

But US fixed-rate mortages are a one-way bet. If interest rates go down, you can simply take out a new loan and use it to pay off the old one. This kind of refinancing has been a major source of consumer demand in recent years, as people have increased their borrowing and used the extra funds to finance home improvements or discretionary spending. By contrast, with the fixed rate loans on offer in Australia and elsewhere, if interest rates fall and you want to repay early, you have to pay a penalty equal to the profit the lender would otherwise have made on the deal.

This is a kind of put option, and if knew my Black-Scholes formulas as well as I should, it ought to be possible to value it (these guys have done it, but I haven’t had time to work through their paper). Looking at the relatively small interest rate difference between fixed and adjustable rate mortgages and present, you’d have to assume very low volatility in future interest rates to make the adjustable rate option the sensible choice.

With the less favorable fixed rate options available in Australia, the choice is less clear-cut and comes down to risk allocation. If you think that most variation in interest rates is likely to come from factors uncorrelated or negatively correlated with your income (such as monetary policy), fixed-rate is best given an equal initial rate. If you think that variation in interest is mainly driven by inflation, and that your own income will rise in line with inflation, adjustable is more favorable.

That’s enough on personal finance. Coming to the economic implications, the growth in adjustable rate mortgages has gone hand in hand with big growth in overseas demand for mortgage-backed securities, notably from China (hat-tip: Brad Setser).

Now from the point of view of a lender, an adjustable rate loan is like a fixed holding of short-term bonds, since it is, in effect, rolled over every time the interest rate changes. So the shift to adjustable rate mortgages is in line with the general shortening of maturity of US debt. All of this, and the Korean kerfuffle early in the week, suggests that foreign investors are edging for the doors, or at least making sure they can see a clear path to the fire escape. A rollover crisis looks ever more likely.

{ 26 comments }

1

David Weigel 02.26.05 at 5:11 am

It’s not quite true that in America, if “interest rates go down, you can simply take out a new loan and use it to pay off the old one.” Well, you can, but it’s usually not a good idea. The fees charged by new lenders are quite high: title searches, insurance, random profit disguised as “document fees”. These negate the advantages of getting the new loan. Last time I figured for me, the new interest rate had to be at least 1% less than the old one to be worthwhile, and with current rates wobbling in the same range for the last couple years, there can’t be much incentive for mortgage holders to flop when tiny changes in the market take place.

2

James J Murray 02.26.05 at 6:11 am

It all depends on the deal you can find. My family (poly fmf triad located in Kansas City, MO) is about to refinance our house to a 5 yr ARM whose rate is locked in for that duration. We’ll be paying off about $40k in miscellaneous debt, and our new payment will be about $200/month less, freeing up a total of roughly $1200/month. Our only cost is the appraisal ($350). Our rate is dropping from 7 to 5%. And in five years, we’ll see what the situation is and deal with it then (assuming there is a US economy at that point).

3

rdg 02.26.05 at 9:47 am

Anyone on an ARM in the US today is making a huge gamble, considering the precarious position of American interest rates.

One hiccup from Asian central banks and the Fed will be forced to jack up the base rate. Any sudden shock to the value of the dollar would have the same effect.

With interest rates as low as they are right now, the small benefit obtained by choosing an ARM hardly makes up for the potential risk of an economic crisis.

4

Matthew Cand 02.26.05 at 10:31 am

I always wondered why, in the UK, fixed rate mortgages are very rare and variable ones are standard, while accross the channel in France it’s the exact opposite. My guess is that a massive transfer of risk slowly occured, from the banks on the population. Any thoughts?

5

Jussi Hakala 02.26.05 at 11:58 am

Variable mortgages are extremely risky for the individual, especially in places where rates are used for political purposes. I wouldn’t buy where politicians control rates.

6

CDS 02.26.05 at 2:14 pm

I’d tend to take the line with rdg and jussi that ARM’s are risky, especially given the current economic climate. It seems people have hopped on the boat over the past few years due to the low interest rates, but it also seems short sighted as interest rates can’t stay low forever (unless the economy stays in the tank forever, and obviously then there’s a whole new set of problems).

7

Cranky Observer 02.26.05 at 2:28 pm

Scenario 1: you get a fixed rate loan. Rates stay the same or go down. The housing market in your area stays stable or increases somewhat. You decide to move. Outcome: you have “lost” some potential profit.

Scenario 2: you get an ARM. Inflation jumps to 10%, interest rates to 15-20%. The housing market in your area tanks. You are forced to sell and cannot find a buyer. Outcome: you have lost (no quotes) your life.

Scenario 2 sound far-fetched? Essentially that happened to my father in the 1970s, and plenty of other people we knew.

Greenspan’s advocacy of ARMs is absolutely disgusing and immoral: another attempt to shift the risks of our society to those who can least afford them and suck the money out of their threadbare wallets to line the pockets of the Trumps, Bushes, Lays, etc.

Cranky

8

dsquared 02.26.05 at 2:37 pm

I always wondered why, in the UK, fixed rate mortgages are very rare and variable ones are standard, while accross the channel in France it’s the exact opposite.

Fixed rate mortgages aren’t that rare in the UK any more; they’re about a quarter to a third of the stock and more like 40% of the flow of new deals.

The reason why UK developed along this line was that the UK mortgage market grew out of the building society movement. The building societies made mortgage loans out of their own deposits, and in general as small local institutions they weren’t at all well placed to manage interest rate risk.

9

y81 02.26.05 at 3:43 pm

Another issue: in many parts of the U.S., home mortgage loans are either totally or effectively “nonrecourse,” meaning that the lender’s recovery is limited to the mortgaged property (the house); the lender may not seek to recover its loan from other assets of the borrower. So there is a further embedded option in the mortgage transaction that needs to be priced: you can always put the house to the lender for the mortgage balance. If you start out borrowing 80% of the purchase price, your downside risk is substantially limited. I don’t know if most academic analyses have taken account of this feature.

10

jussi hakala 02.26.05 at 4:15 pm

“The building societies made mortgage loans out of their own deposits, and in general as small local institutions they weren’t at all well placed to manage interest rate risk”

Especially not if rates were politicially controlled, Daniel, which they still are in some way, aren’t they?

One wonders how UK home-owners reacted when rates were upwards adjusted several times in one day just to rescue the government ERM policy (which they couldn’t).

It seems to be risky owning property in the UK, if you don’t mind my saying so.

11

eric 02.26.05 at 5:26 pm

I have a 7/1 arm on my house. It has a lifetime APR cap or ~8% so even if intrest rate syrocket I’m not hosed.

I picked it because the terribly low monthy payments allow me to contribute much more pricipal every month so that in theory by the time it start fluctuating I will have payed off a good chunk of the principal. I think that makes quite a bit of sense, but I do agree that many people may be lured in by the low rates unaware of the overalll danger that they can pose if you choose to pay the minimum.

12

Cranky Observer 02.26.05 at 5:27 pm

> you can always put the house to the
> lender for the mortgage balance.
> If you start out borrowing 80% of
> the purchase price, your downside
> risk is substantially limited.

Except that the prices you pay for everything from loans (after the 7-year period) to auto insurance to groceries will go up for the rest of your life, which is a bit of a cost.

Cranky

13

Mr. Mortgage 02.26.05 at 5:36 pm

Folks here are overstating the risk of most ARMs. ARMs (in the U.S., at least) usually feature a beginning phase (5 yrs., say) during which the initial rate is locked in. After that, there are usually caps as to how much (up or down) the rate can change every year after the beginning phase is over. Furthermore, there is usually an absolute cap above which the rate cannot rise, no matter what is happening more generally to interest rates.

One reasons ARMs are attractive is that if they have an initial lower rate, the monthly payments are more affordable. This means that persons who might otherwise not be able to afford to carry a mortgage can do so. Since people tend to earn more as they get older, this gives them time to ramp up their incomes so that, when the initial phase is up, they are more capable of making higher payments, if the rate adjusts upwards. Since owning a home is a great way to generate long-term personal wealth, and if ARMs make owning a home more affordable, they are to be applauded.

14

joel turnipseed 02.26.05 at 5:40 pm

On fixed vs. ARM: doesn’t the average mortgage turn over in five years and don’t most ARMs have a cap as to annual rate increase (usually 1 or 2 percent)? On this, you could pretty easily say that unless you are really risk averse & plan to stay in your house for a long time (or think you might have trouble getting out in rough waters), there’s no big risk to an ARM.

As to all the refinancing, with the exception of the unbelievably-dangerous new ability to borrow up to (or beyond) 100% LTV, I’d much, much rather have my debt rolled up into equity line ARM than to blood-sucking credit card companies’ terms. I would think, on this line, that the move to equity debt from other forms of credit is a long-term stabilizing move, no? (Except where, as I said, insanity allows you to borrow more than your house’s value–not to say realty fees, etcetera, if you need to get out.)

15

james 02.26.05 at 5:58 pm

eric>>I have a 7/1 arm on my house. It has a lifetime APR cap or ~8% so even if intrest rate syrocket I’m not hosed.

16

Cranky Observer 02.26.05 at 6:30 pm

Electronics stores don’t offer extended warrenties for the benefit of consumers. $10 million salaries and $100 million bonuses don’t come from nowhere.

Financial institutions did not develop ARMs to make less money.

A house is a place for you to make you home; it is a shelter and part of the foundation of a family. It may have some of the characteristics of a financial instrument, but that is not its purpose. If you think otherwise, you are ripe for plucking by those who get the $100 million bonuses.

Did you receive a $100 million bonus check in January?

Cranky

17

Mr. Mortgage 02.26.05 at 8:48 pm

to cranky observer:

Of course “Financial institutions did not develop ARMs to make less money.” But so what? That these financial institutions benefit from ARMs does not mean that I and other persons don’t benefit from them, too, in important ways (even if the lenders benefit more).

It is true, as you say, that a house is usually “a place for you to make your home; it is a shelter and part of the foundation of a family.” But failure to see it also as a “financial instrument” risks doing a great disservice to yourself and your family, and it disadvantages others who would benefit from you being wealthier.

18

Richard Bellamy 02.26.05 at 10:29 pm

Missing so far from the conversation is the fact that most people move every five or seven years or so. It is the rare bird who buys a house with a 30 year mortgage and stays there for 30 years.

For most, the adjustable mortgage is best, because they’ve moved on by the time of the adjustment.

19

Anthony 02.26.05 at 11:00 pm

When I bought my house, the rates were 5.75% for a 30-year fixed, 4.75% for a 5/1 ARM, and 4.375% for a 3-year ARM. I got the 5/1, which means I have the 4.75% interest rate for 5 years, after which the rate can rise based on an index over which the bank has little control. A 30-year fixed would make my payments 12% higher in the first 5 years. I’m still not sure if I should have traded the extra two years security for the lower interest rate, as it’s likely that I will sell this house and buy another in two years’ time.

Incidentally, Mr. Quiggin, you’re not entirely correct about the nature of refinancing in the United States: many loans have prepayment penalties (this is negotiable, in exchange for points or interest rate), which can be steep. They’re not necessarily set to the lender’s profit, though my girlfriend has a loan which had a 3% prepayment penalty in the first year – 3% would be a good profit. But few loans have prepayment penalties past the third year of the loan, and the IRS has its own penalty for selling the house in the first two years. Prepayment penalties can come in “soft” and “hard” varieties – hard penalties apply even when the house is sold, soft penalties don’t apply for the sale of a house, and can sometimes be removed if you’re refinancing with the same lender. So the differences between the American and Australian models are more subtle than you’ve let on.

There is another issue in the house market which makes a difference in the advisability of ARMs: house-price inflation. Generally, in the “red states”, house price inflation matches the inflation of inputs, and is pretty susceptible to interest-rate changes. In the “blue states”, however, the regulatory burden on house-building causes house-price inflation far out of proportion to inflation of labor and buliding material prices. Anecdotally, I spoke once with a woman who’d bought a house in a middle-class black section of Oakland; it had appreciated about $50,000 per year for each of the past 6 years, nearly tripling in value. While that’s an extreme case, Santa Clara County had nearly no drop in house prices (except in the $1million+ range) despite the loss of 25% of its jobs over two years. A market that can be so bouyant in the face of such adveristy justifies a greater degree of risk-taking than one where prices are stagnant in a boom.

20

Jack 02.27.05 at 12:47 am

One enormous advantage of the US mortgage system is that it is very easy to compare deals. The UK does have massive amounts of fixed rate mortgages but they are usually only temporarily fixed and then not over standard periods. It is almost impossible to get mortgage lenders to tell you the formula they use to calculate the repayments so they have almost complete freedom to twist the rates.

Some of the fixed rate deals are very good indeed for the two or three years they last but somehow mortgage banks can make more than 40 % return on equity, even with balance sheets already obese for regulatory reasons. They do that by confusion and inertia. If you don’t switch as soon as your fixed period is over you will have your eyes ripped out.

When fully fixed mortgages on reasonable terms such as those issued by Standard Life come out they fly off the shelves. UK mortgage lenders typically keep most of their stock on their own books which should tell you something.

The confusion caused by the insane complexities of the UK mortgage system reduce price competition, enhance the importance of brand and push customers into the hands of commission paid advisors.

They mortgage companies can display awesome mendacity when pressed on this matter. For example the head of financing of one leading lender told me that they could not offer fixed rate mortgages because there was no derivative market running to 25 years. In fact at the time the long end of the yield curve was downward sloping.

Valuing mortgage backed securities is a tricky business both because the option is quite awkward and because it is not exercised optimally for some of the reasons outlined above so if you bid as iff the holder of the option were fully rational you will demand to high a price. Much of the work goes into assessing the deviance of early redemption from full financial rationality for example because of house sales or oversight or costs involved in remortgaging.

An additional reason that the floating rate persisted for so long is that for some time there were massive tax breaks for pension borrowers which went a long way to offset the risks the floating rate might bring.

Gordon Brown has even muttered about setting up some kind of Fannie Mae in the UK.

Fat mortgage profits are one of the reasons that UK banks, although massively more profitable than their European counterparts, did not expand into Europe. ( At one time Deutsche Bank would have had only the sixth highest market capitalisation in the UK.) They had a better market but not better technology, practice or management.

As soon as it becomes possible to argue the toss about the relative virtues of two competing products, the consumer is sunk. There may well be issues with Fannie Mae but much of the animus against it is fueled by the profits the banks would make if Fannie Mae et al. were removed from the market. I’m not entirely sure what would be wrong if Fannie Mae were to have an explicit guarantee from the state. The government had to bail out the S&L’s and Citibank so why not Fannie Mae if it can deliver greater efficiency in the mean time?

21

jussi hakala 02.27.05 at 8:46 am

“Missing so far from the conversation is the fact that most people move every five or seven years or so. It is the rare bird who buys a house with a 30 year mortgage and stays there for 30 years.”

Everyone I know buys a house because he likes it and wants to live there, not because he wants to butterfly to another every 5 to 7 years, Richard.

Are you sure you’ve got that right?

22

Alex 02.27.05 at 12:07 pm

Ahem…”“The building societies made mortgage loans out of their own deposits, and in general as small local institutions they weren’t at all well placed to manage interest rate risk”

Especially not if rates were politicially controlled, Daniel, which they still are in some way, aren’t they?

One wonders how UK home-owners reacted when rates were upwards adjusted several times in one day just to rescue the government ERM policy (which they couldn’t).

It seems to be risky owning property in the UK, if you don’t mind my saying so.
Posted by jussi hakala · February 26, 2005 04:15 PM

Er…British interest rates are NOT under some form of political control – they are under the control of an independent central bank and have been so since 1997. The Bank of England Monetary Policy Committee is responsible for setting the rate in order to hit a 2% of CPI inflation target over a 2 year forecast horizon.

“Homeowners” reacted very strongly indeed to the multiple-rises-in-a-day crisis: they took the first opportunity to Kick the Bums Out and have kept the bums in question outkicked since

23

Matthew2 02.27.05 at 12:54 pm

Daniel: thanks for the info. I know fixed rates mortgages seem to get more popular in the UK, but they’re still much rarer than in France where they are standard. Nice explanation.
In the UK there are many people that take very high and overvalued mortgages, they can just about pay, to get high on the property ladder straight away. When you combine this with ARM, it seems like a recipe for disaster…

24

jussi hakala 02.27.05 at 6:57 pm

“Er…British interest rates are NOT under some form of political control – they are under the control of an independent central bank and have been so since 1997. The Bank of England Monetary Policy Committee is responsible for setting the rate in order to hit a 2% of CPI inflation target over a 2 year forecast horizon”

Daniel, my information is that the Bank of England sets interest rates according to an inflation rate target, and is therefore nominally independent.

But the inflation rate target is set by a politician, namely the Chancellor of the Exchequer, and so actually it IS politically controlled. You might want to view this differently, but the facts give you clearer water.

25

Kevin Donoghue 02.27.05 at 8:13 pm

“It seems to be risky owning property in the UK, if you don’t mind my saying so.”

It is risky owning property anywhere. If people emigrate, rents will fall and so will property prices.

As to the independence or otherwise of the Bank of England, the comparison being made in this thread is with France. Is anybody claiming that the Banque de France was independant?

26

Anthony 03.01.05 at 9:44 pm

Jussi –

I don’t know if you’re a US resident, so you may not have direct knowlege of the US market, but in the US, the average house-buyer moves to another house within 5 to 7 years. Perhaps they don’t intend to, but people move to different cities for jobs, people move to larger (or smaller) houses as their families grow (or shrink), and people move to better neighborhoods as their fortunes increase.

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