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Making the Numbers Dance…. Part 2

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I am going to say something that will likely make your head explode, so I would encourage you to get some towels and maybe a mop before reading the next sentence.

There is nothing wrong with an adjustable rate mortgage.

 

Yes, you read that right. No, it was not a typo.

 

What’s that you say….weren’t adjustable rate mortgages primarily responsible for the biggest economic downturn since the great depression?

 

¬†Well, yes and no. The first thing you need to understand is that most adjustable rate mortgages are not fully adjustable, they are actually ‘fixed-adjustable hybrid mortgages’. When referring to a 3, 5, 7, or 10 year adjustable mortgage, that number actually refers to the number of years that the rate stays fixed at the beginning of the mortgage term; the adjustable rate mortgages offered by banks and mortgage companies (Fannie, Freddie and FHA) are all actually 30 year mortgages. After the initial introductory period they can adjust, but typically the initial adjustment is capped at 2% and the factors determining the adjustment (the margin and the index) insure that it likely will not even adjust the full 2% (if it adjusts at all), and when the loan is underwritten- in the case of the 3 and 5 year product- the borrower is qualified (their ability to repay) is based on a rate 2% ABOVE the introductory rate.

 

The adjustable rate mortgages offered during the sub-prime boom were a very different animal. Many of them adjusted after 2 or 3 years, and the first adjustment could be as much as 5%. Considering that the loan qualification guidelines were much looser for subprime loans to begin with it was truly a recipe for disaster. Most adjustable loans were sold as ‘band-aid’ loans, meaning that the idea was for the borrower to clean up their credit in the short (2-3 year) period before the first adjustment, so they could refinance into a conventional loan before the rate increased. Sadly most borrowers never did that, and they were merely refinanced into ANOTHER adjustable loan; once home values started declining in the late 2000’s they could NOT refinance and were therefore stuck with a rate that increased to the point that it was impossible for them to pay.

 

In our current lending environment, I have seen many borrowers from the financial sector- with an understanding of the factors that control the rates and the adjustments- choose an adjustable rate product over a fixed rate product. They monitor the loan term and the market factors carefully with the knowledge that they will either refinance again before the adjustment period or live with the increase as long as the market factors remain relatively stable, in which case the increase will be slight. Another reason for choosing this product would be if you are only staying in the house for a short period time, in which case this would be a no-brainer! As long as you maintain your credit, your income remains stable or increases, and your equity position is strong, there will almost ALWAYS be an adjustable product available that will give you a lower payment than the fixed option.

 

THIS IS NOT FOR EVERYONE; most of us do not want to worry about tracking financial indices and guessing what will happen to their loan once the introductory period is over which is why the 30 year fixed is, by far, the most requested mortgage product. That having been said, the client that I mentioned at the beginning of ‘Part One’ did NOT refinance into a 30 year fixed loan at 3.625%; he opted for the 5 year fixed/adjustable and ended up close to 3%.

 

Coming soon…. an insiders view of ‘The Big Short’.