Default or fixed rate mortgages

From consumer loans to installment loans to credit cards and now to interest-only adjustable rate mortgages. The old adage, “If it sounds (looks) to good to be true, it probably isn’t,” is still as true today as it was in 1959 when newspaper headlines read “Never have So Many Owed So Much.” Every week since September, the Business Week magazine has run an article on the housing market. Newspapers run stories each week either focused on families that are losing their housing due to inability to meet changing rates based on the adjustable rate mortgages or focused on the ever increasing mortgage defaults on the side of lending institutions. Alan Greenspan has already warned that the housing fallout will impact other areas of the economy and he “puts the odds of a recession by the end of the year at one in three.” (according to a New York Times article.) Wouldn’t it just be smarter for banks to leave the interest rates alone, or rewrite the loans at a fixed rate. This way families can continue to make their mortgage payments and banks don’t have to worry about default loans. This seems like a win-win situation to me that would help the overall economy and prevent a further recession.


Sebastian said...

I agree that "the housing fallout will impact other areas of the economy." However, I also think that it is the fault of many consumers for getting involved with these risky ventures in the first place. As consumers, we need to look at the long term, especially when buying a home. Historically speaking, the current mortgage rates are quite low. If you look at what the rates were in the eighties, you will find that today's rates are half of what they were. Getting involved in an adjustable rate mortgage is risky from the beginning. In the end, we need to be educated consumers and realize that the market changes and cannot be predicted for the most part. Many people were caught up in the housing boom and are now realizing their mistakes.

joseph said...

If the Federal Reserve increases the discount rate considerable that would mean that banks will have to start raising the interest rates on mortgages too. Banks make their money on what is called the ‘spread’. They make money on borrowing at a lower rate and lending that money at a higher rate. Given the state the economy is in, the Federal Reserve can have a huge impact on the going market rate. This might make it impossible for mortgage bankers to sustain today’s low interest rates.

Jada said...

I agree with Sebastian that we do indeed need to become a more educated consumer/society. However, there are many people buying homes without higher education, understanding, and/or knowledge and they relied on their banker to provide reliable information to them in their decision making. We were presented with an 7 yr/ARM loan on our first home and it sounded like a great deal on the surface, until my parents told me what their first home loan was at (13% in 1979) and when I realized the potential for the increase in rate over time it obviously was not a wise decision. The bank continued to push it with us stating that we would be in our first home for less than 7 years and so it was to our benefit. They pushed so hard we ended up with a different lending institution. I wonder how many consumers gave in to the 'pressure'. Banks and mortgage companies should not be allowed to use pressure tactics. I almost wonder if it is not conflict of interest, except that the banks are in as much trouble with the increasing number of default mortgages.

Dr. Tufte said...

Unfortunately Jada, banks are very willing to rewrite mortgage terms if the conditions are correct. The problem is that most borrowers have multiple conflicting problems. The situation has not been made easier by politicians who place moral hazards in the path of borrowers.

Sebastian is not quite right about the risk involved. An ARM is not risky for someone who can expect their income to change with interest rates. Unfortunately, most people are not presented with this basic matchup: if you're income is stable choose a fixed rate, and only choose an ARM if your income is positively correlated with interest rates.

There are a couple of problems with Jada's points. First, there isn't a lot of reason why people couldn't research this more before talking to a bank - after all, they are selling something. Secondly, the level of understanding on the part of the person at the bank is probably not as good as that of the students in this class. Third, the pitch about 7 years is actually pretty reasonable. You don't usually get yourself into trouble with an ARM if you don't hold it for too long, and you always have the option of selling the house. A lot of what we are "informed" about is people who probably should be selling, but somehow they think they have a right not to make the choice that other people must have.