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.