Are ARMs Naturally Toxic?

Adjustable rate mortgages are at the heart of the current mortgage crisis in America. And almost everyone who has a recent one wants it converted to a fixed rate loan as soon as possible. With good reason. But are ARMs naturally toxic to consumers?

Not necessarily. ARMs are like firearms, they’re tools which can be used for good or evil. And like firearms, they should only be used with care and education.

My family has an ARM and it has worked out well for us. But for a long time now, my type of ARM has become an endangered species, replaced by a creature that seems purpose-built to eat consumer wealth like an anaconda eats mice (or its young).

My household is very unusual in many ways. We bought our home in 1994 and we’re still paying the same mortgage we used to buy the house. That makes us a very rare family these days. Ask your friends and relatives, almost no one escaped the last fifteen years without refinancing at least once or twice.

We used an ARM that was very traditional in the early 90s, it began with a “teaser” rate like the more recent versions. It lasted only one year. Thereafter it could go up or down by no more than 2% per year, with only one adjustment per year. The floor below which the rate cannot go was actually comparable to the teaser rate (about 4%) and the ceiling was similarly reasonable (around 10%).

These features by themselves are rare with more recent ARMs. Many, probably most, subprime ARMs today effectively only adjust up, never down. The floor (after adjustment) for the interest rate will never allow the rate to go back to the original teaser rate and the ceiling sounds more like a credit card, often in the 16-20% ranges. To top it off, the adjustments often are scheduled every six months instead of annually. And most of these loans come with prepayment penalties which will take a large bite out of equity if you payoff or refinance before enough profit is squeezed out of you. The only “upside” of these ARMs compared to the older version is that they often come with a two- or three-year teaser period — just enough time to forget home much money your mortgage broker made selling you this nightmare!

But the true killer in modern ARMs is the little-noticed index used. My ARM relies on the old fashioned one-year Treasury bill rate of interest, so I’m typically paying each year about 2.5% more than the government pays to borrow money for a year. Several years ago, mortgage bankers realized this was not very profitable so they quietly switched the index to the London Inter Bank Offering Rate or LIBOR.

By switching to LIBOR, lenders exposed American borrowers to international
interest rate fluctuations. It also works out that LIBOR is usually higher than T-bill and they don’t always move in synch. Where my family only has to pay attention to how much it costs the government — our government — to borrow money, most folks with subprime ARMs must worry if competition for loans in international commerce is heating up and driving up their rates, even if American interest rates are coming down. When the Federal Reserve starts cutting rates, we know our mortgage payments will go down — our neighbors with subprime ARMs may o may not benefit.

There are other reasons why our ARM is working out for us. We’re cheapskates who worry about paying off debt before borrowing any more. We put (gasp!) 20% down on a modestly-priced home. And when rates and the payments went down, we paid more anyway. If you have a decent ARM and you borrow less than you can afford, you can take full advantage of an ARM’s periodic re-amortization.

When an ARM adjusts, the payment is calculated based on the remaining principal, new rate of interest, and the remaining term of the 30-year loan. So when we make additional principal payments, they benefit us next year by reducing the balance spread over the rest of the loan — rather than coming off the back-end of the loan as with a fixed-rate loan. I don’t happen to think that matters from a financial planning standpoint. But psychologically the reward is more immediate. And that encourages you to keep doing the right thing — paying off the debt faster than you must, when you can.

It also means when the rate moves against you, the payment won’t hurt as much — and you have more “cushion” in your budget when things get tough. For example, last year my rate went up about 5/8th of a percent. Because of years of paying “extra” the actual increase in my payments was only $8.96. This year, because the Fed has cut rates so aggressively, my rate dropped the maximum 2% and my payment fell about $32/month.

I’m not bragging. There are serious risks in borrowing this way. You should only do it as part of a complete financial plan that you can carry out in good times and bad. But a reasonably-priced and structured adjustable rate mortgage does not have to be toxic. It just happens that mortgage bankers turned a product that was useful for a minority of consumers with a plan into a mass-market product to sell to many consumers who never should have been exposed to such risks. That is wrecking the lives of thousands of homeowners and also wrecking the portfolios of investors across the globe.