« Back in the swing of things | Main | "Monopoly" embraces the cashless society »
July 25, 2006
Refinancing those ARMs
The NY Times has a good article on the re-fi boom.
It is the latest twist in the gravity-defying world of the high housing prices and exotic low-rate mortgages: As monthly payments on adjustable-rate mortgages are starting to balloon, many Americans have found a way to put off the day of reckoning.
...
When that happens, for instance, a typical borrower with a $200,000 A.R.M. could see his monthly payments increase nearly 25 percent when the A.R.M. adjusts from 4.5 percent to 6.5 percent. In total dollars, that is an increase from $1,013 a month to $1,254.
Yet instead of paying more now, many borrowers are refinancing into their second or third adjustable-rate mortgage, loan data indicate and industry experts confirm.
So far, the number of borrowers refinancing this way is relatively small — several hundred thousand in the estimate of the credit ratings firm Fitch Ratings — but mortgage industry officials and analysts expect the numbers will surge next year. In doing so, these borrowers are pushing out any eventual shock of higher payments by another two or three years, if not longer.
“They get another two- or three-year hybrid with a low introductory rate to keep payments down,” said Frank E. Nothaft, a vice president and chief economist at Freddie Mac, the mortgage buyer. “They’re trying to put it off forever, which is O.K. as long as interest rates are low. But when they start to spike, then it’s going to be more problematic.”
Obviously they are chasing after the low "teaser" rates that come with a new ARM, which, though higher than a year ago, are still reasonable. They'd just better hope that Bernanke does a good job of warding off inflation...and that their house continues to appreciate. Do you feel lucky? The article continues...
But the refinancing also represents a doubling-down on a bet that housing prices will continue to rise on the West and East Coasts and in other hot markets. If the value of the home falls closer to the amount of the loan, that could curb the ability to refinance, and may prompt the homeowner to either invest more in the home or to sell it.
Such would be the case if you had an interest only ARM and a high loan-to-value ratio.
With his new loan, his third adjustable-rate mortgage, Mr. Perry, a former technology project manager, cashed about $200,000 out of his home’s equity and is investing it into his four-year-old financial planning business. “I could have sold my house and made my family move,” said Mr. Perry, 42, who lives with his wife and a 3-year-old son in Danville, about 20 miles east of Oakland. “But I didn’t do that. I said, ‘Look, I want to start a new business,’ and this product allowed me to do that.”
He said he was taking on more risk than many of his clients would be willing to because he believes his business will continue to grow. After spending 15 years in the technology industry, which put him on the road constantly, Mr. Perry said that being self-employed allowed him to spend more time with his family, which he also expects to grow. As far as the house, he said: “I am not going to be here for 30 years. Why is it important to have a fixed mortgage?”
And who am I to fault a person for taking a risk. This strategy can pay off, and it is quite possible that the subject of the article is just the type of person who can really benefit from this. It all depends on a person's willingness to take on a risk and their fallback position if things don't work out as planned. That is a highly individual decision. I predict that these stories will be told with increasing frequency. Some will turn out better than others.
However, there is one piece of this story that the Times left out. I was about to write that they omitted the fees that go along with refinancing. But a new blog worth reading, Credit Slips, beat me to it. (Hat tip to Stephen Bainbridge for calling attention to this new site.)
The Times article does not emphasize how expensive this re-refinancing is. Closing costs and fees all get lumped back in to increase the outstanding balance. Keep in mind that these buyers couldn’t make market-based payments on the old, lower balance. The odds of making those payments on the new, higher balance are worse than those in any Las Vegas gambling parlor.
In the industry, these mortgages are called 2/28s. The numbers refer to the teaser period (the 2) and the real payout period with the higher-than-market interest rates (the 28). How can the “2” be profitable for the lender, if the debtor re-fi’s the loan without paying the high 28 period? Many of these loans carry a pre-payment penalty, along with up-front fees and closing costs that make them instantly profitable. Even if the debtor refi’s immediately, the amount paid off includes all these costs, making the effective interest rate for the “2” ten or twenty times higher than the stated interest rate. In the 2/28 game, the lender nearly always wins.
Could re-refinancing be the knife that will cleave what is left of the middle class? There will be those who have fixed-rate mortgages, who pay off their homes, and who have something for retirement or savings if a catastrophe hits. And then there will be those who live in houses, paying high rent, always vulnerable to rate hikes, flat real estate markets, job layoffs, etc. That last group will nominally be called "homeowners" just like the first, but they won't really be. They will play the 2/28 game until they go bust.
In Vegas, the odds always favor the house. In banking, transaction costs can make it difficult (though not impossible) to get free money. Those prepayment penalties can be steep. So shop around for the lowest fee structure. With good credit, there are probably still some to be had. However, many of these people do have less than perfect credit. They will end up paying the fees. While I stop short of condemning these types of mortgages, it suffices to say that one has to weigh the risks carefully, and check the fee structure on the loan. Such loans do increase the housing opportunities for many people, and many will use them to their long-run advantage. However, the bank needs its cut, and someone, somewhere will pay the freight.
Or, as economists are fond of saying, "TANSTAAFL!"
Posted by William Polley at July 25, 2006 8:26 PM
Trackback Pings
TrackBack URL for this entry:
http://www.williampolley.com/cgi-bin/mt-tb.cgi/561