Mortgage Selection in the Post-Crisis Market

February 15, 2010, Revised March 28, 2011

One of the most critical decisions mortgage shoppers must make is the type of mortgage that best meets their needs. The importance of the decision has been heightened by a post-crisis market in which price differences between all categories of mortgages are unusually large.

The decision process can be divided into three parts: The first is whether to select an adjustable rate mortgage (ARM) or a fixed-rate mortgage (FRM). All ARMs today are 30 years, and in this article we compare them to a 30-year FRM. The second part of the decision  process, for those who elect the FRM over the ARMs, is to select the term of the FRM. The third part is to decide whether or not to take an interest-only payment option.

 FRM Versus ARM

FRMs offer borrowers interest rate and payment stability. This is particularly advantageous to borrowers who are not sure how long they will have their mortgage, and who find the FRM payment affordable. ARMs offer borrowers a lower interest rate and payment in the early years, which is particularly advantageous to borrowers who know about how long they will have their mortgage. ARMs also work for borrowers who require the lower initial rate to make the initial payment affordable, and can handle the risk of rising payments in the future.

Taking Account of Price Differences, Borrowers should take account of the price differences between FRMs and ARMs in deciding between them. If there is no or little price difference, there is no good reason to select an ARM.

This was the case when I last addressed the issue in 2006. On October 8 of that year, I shopped for a $320,000 loan on a $400,000 single-family home in California to a borrower with excellent credit and adequate documented income. The market at that time offered this borrower a 30-year FRM at 6% and zero points, and a 3/1 ARM at 5.75% and zero points. The 5.75% rate held only for 3 years, after which the rate adjusted every year.

My conclusion at the time was that the .25% price difference between the FRM and the 3/1 ARM was not large enough to justify the price risk on the ARM – with the possible exception of borrowers who confidently expected to be out of their house within three years. ARMs with initial rate periods of 5, 7 and 10 years were priced between the FRM and the 3/1 ARM, making them even less attractive.

In January 2010, the price differences were much larger and ARMs were correspondingly more attractive. On January 8, 2010 I shopped the same loans described above. The 30-year FRM was 5.125% and the 3/1, 5/1, 7/1 and 10/1 ARMs were 4%, 4.125%, 4.5% and 4.875%, respectively. The borrower taking the 3/1 ARM rather than the FRM saved 1.125% in rate rather than .25%. Note that while market prices change every day, the price differences between FRMs and ARMs are relatively stable in the short run.

On March 28, 2011 the differences were even larger. The spread between the 30-year FRM and the 3-year ARM was 1.625%!

ARM Borrowers With Short Time Horizons: When the pricing is advantageous, the most logical candidate for an ARM is the borrower who expects to be out of the house before the initial rate period is over. While few borrowers can be certain about this – life sometimes confounds our best plans -- the rate saving should substantially outweigh the risk of being caught by a rate adjustment. If you expect to be out within 3, 5, 7, or 10 years, select a 3/1, 5/1, 7/1 or 10/1 ARM, as the case may be.

ARM Borrowers Who Need the Lower Initial Payment: A second reason to select an ARM is the lower initial payment associated with the lower initial rate. In some case, the borrower needs the ARM in order to meet the lender’s underwriting requirements, which include maximum ratios of mortgage payment and other expenses to borrower income. In other cases, borrowers need the ARM to meet their own views of what constitutes an affordable payment.

Borrowers who select an ARM because they need the lower payment assume the risk of a possible rate and payment increase at the end of the initial rate period. Borrowers faced with this decision should ask themselves "Is this a risk worth taking," and "can I afford to take it?"

The best way I know to deal with these questions is by determining what will happen to the rate and payment on the ARM if market interest rates change in ways that the borrower specifies. This "scenario analysis" provides a measure of the risk if rates increase, and the benefit if they don’t. It also allows borrowers to determine the extent to which they can reduce the risk on the ARM by making the larger payment that they would have made had they selected the FRM.

To do a scenario analysis, you must know all the features of the ARM that affect future rates and payments: the rate index used by the ARM, its current value, the margin that is added to the index at a rate adjustment, rate adjustment caps, and the lifetime maximum rate, You should have this information anyway, otherwise, you don’t know whether you have found the best deal on your ARM.

Readers who want to do a scenario analysis on an ARM will find an explanation of how to do it, with an example, at Choosing Between Fixed and Adjustable Rate Mortgages. 

Selecting Among Different FRMs

In today's market, the price differences between FRMs of different term are also unusually large. On January 8, 2010 the rates for prime borrowers on 40, 30, 25, 20, 15 and 10-year terms were, respectively, about 5.625%, 5/125%, 5.125%, 4.625, 4.5% and 4.25%. On March 28, 2011, the spreads were a little larger. They largely reflect the increased importance lenders now attach to borrower equity as their protection against default. With home prices no longer rising, the faster pay-down of loan balances on shorter-term mortgages has enhanced value. Lenders will cut the price if you commit to paying down the balance faster.

Selecting the term is in a sense a judgment by the borrower of the relative importance of the present and the future. A longer term has a lower payment, which favors the present, but a slower pay-down of the loan balance, which is burdensome in the future. By pricing short-term loans lower, the market encourages borrowers to favor the future, but this runs against the very powerful tendency of most borrowers to focus on the present. While clearly the payment must be affordable, many borrowers could afford more but give the future a low priority..

The price of being fixated on the present can be high. Lets take the extreme case of a 10-year versus a 40-year term. On a $100,000 loan, the payments are $524 and $1,024, almost 2 to 1. The borrower taking the 40-year saves $500 a month in payment, or about $30,000 over the first 5 years. But at the end of the 5 years, that borrower will owe $96,161 compared to only $55,282 owed by the borrower who took the 10-year. The difference in balances is $40,878 compared to the $30,000 difference in payments. The larger difference in balance is due entirely to the lower rate on the 10-year. The borrower with the 40 paid $10,878 more in interest.

Some borrowers who can afford the higher payment on a shorter term select a longer term with the intention of investing the difference in cash flow. This is a really dumb idea, even for a borrower who has the iron discipline required to execute it. The pitfall is that, because of the higher interest rate on the longer term loan, the return the borrower needs to earn on the cash flow to come out ahead is just too high.

For example, if the borrower selects the 30 at 5.125% rather than the 15 at 4.5%, he has to earn 6.73% over the 15 years just to break even. If the loan is paid off in 10 years, the breakeven rate is 8.12 %. And over 5 years, it is 12.35%. I don’t recommend this strategy. 

Selecting an Interest-Only Payment Option

A mortgage is “interest only” (IO) if the required payment for a specified period, usually 5 to 10 years, consists only of the interest, though borrowers have the right to pay more if they want to. The option to pay interest only carries a price, relative to the price of the identical mortgage without the option. The price is higher than it was before the financial crisis, reflecting the heightened importance lenders today attach to balance reduction as a way of reducing default risk.

On a prime loan with 20% down, ARM borrowers pay a rate about .375% higher for a loan with an IO option. On a 30-year FRM, the rate is about .5% higher. If the loan is a cash-out refinance, the price difference is more like .75%. And when the loan is on an investment property, it rises to 1%.

My Tutorial on Interest Only identifies 6 reasons borrowers might have for selecting a loan with an IO payment option. I don’t recommend doing it to invest the cash flow savings, for the same reason I wouldn’t select a longer term. Because of the higher interest rate on the IO, the return you need to earn on the cash flow to come out ahead is too high. Neither is this the time to use an IO to stretch the amount of house you can buy, or to finance a quick in-and-out transaction.

Borrowers with fluctuating incomes who attach a high value to the flexibility the IO mortgage gives them may find the IO price worth paying. When their finances are tight, they can make the IO payment, and when they are flush they can add a substantial payment to principal. Such borrowers must be disciplined enough to make the payment to principal when they aren’t obliged to.

Another group of borrowers who may find an IO worth the price are those forced to close on a house purchase before their existing house is sold, and want to use the proceeds of the sale, when it occurs, to reduce the payment on the new mortgage. IOs are the only mortgages on which a payment that reduces the balance results in a lower required payment the very next month. However, not all IOs work this way, on some the payment doesn't change until the anniversary month, and on others it doesn’t change until the end of the IO period. Anyone contemplating an IO in order to obtain an immediate payment adjustment feature, needs to inquire about this. Note: Get it in writing!

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