But, but, wait, wait...
it's "industry standard"!
SECU members and most consumers believe that a 30-year fixed rate mortgage is a better choice than an ARM.
It just appears to make common sense, that if a borrower can lock in a fixed rate, it has to be better than a mortgage with a rate which might move upward, right?
Most folks think that way and the mortgage industry works hard to make you continue to believe so - because it's in their best interest. But we'll look at that later, let's focus on just the individual borrower for this round.
First consideration: The interest rate on an ARM can "move" in three directions: 1) lower, 2) not at all, 3) or higher. Hope we can agree that we only need to study one of those possibilities, i.e. (#3), because if rates move lower (#1) the ARM borrower will pay less; and, if rates don't move at all (#2) the borrower also pays less because ARM rates are priced lower than fixed rate mortgages (check it out!).
So, in two of the three possibilities for market rate shifts, the SECU borrower will pay less with the 30-year ARM mortgage. Easy enough, shouldn't be any arguments there.
Second consideration: But its that last possibility of rising market rates on which consumers focus, fearing rising monthly mortgage payments which they will not be able to afford. A very reasonable concern, but lets look at the facts.
You should know that the SECU Board and staff always used to look for financial solutions which were better for the members and left extra money in their pockets. Isn't that what a member-owned cooperative is supposed to do? Over the years numerous types of ARMs were tried (1 yr, 2 yr, 3yr ARM versions etc). The 5-year ARM seemed to be the best fit and also is the mortgage most used in developed countries.
The example: The 5-year ARM rate can adjust only every 5 years by no more than 2% and by no more than a total of 6% over the 30 year life of the loan. In our example, we use the average price of a new home ($300,000) and a fixed rate of 6.25% and an ARM rate of 4.25%. (Doesn't matter which house price you use [down-payment, taxes, insurance other fees are assumed to be @ the same] or whether you use a different current market rate...the relative calculation results will be the same)
The monthly principal and interest payment on the 30-year fixed rate loan is $1,847 for the next 360 months (30 years).
The monthly principal and interest payment on the 5-year ARM is $1,476. the SECU borrower will save @ $22,260 ($1,847 - $1,476 = $371 savings per payment x 60 payments) over the first 5 years. If market rates decline or don't move, the SECU member will save at least another $22,260 in the second five years!
Worst case: But what happens if rates soar?!!? Well, the SECU member's rate will increase in years 6-10 to 6.25% and the monthly payment will be $1,847 - the same rate and payment as the 30-year fixed rate - except the member is still ahead $22,260! In year 11-15 if rates jump another 2%, then the $22,260 gain will disappear, but the ARM borrower will still be better off due to lower fees and mortgage insurance costs.
😎 An SECU ARM borrower in the worst case is a sure winner ($22,260!) in the first 5 years and no worse off through at least the first 15 years. If market rates decline, the SECU ARM borrower is a sure winner every year the ARM lasts. If market rates remain the same, the SECU ARM borrower is a sure winner every year the ARM lasts.
✅ Might note that the average 30-year mortgage lasts only 12 years. (A recent commenter said that it was now 7 years, not 12 years, which actually makes the case for the ARM even better!) Under any circumstances, few 30-year fixed rate mortgages last more than 12-15 years.
✅ Might also note that President Trump - and now the Federal Reserve - are predicting that market rates are declining - and will continue to do so.
SECU employees do a great job at educating members about how an ARM is very often the better option. What would your argument be against offering a 30 year fixed if the member is educated on an ARM and still wants the 30 fixed?
ReplyDelete9:13 pm That is a great question and at the core of the problem with all the risky, potentially unsound infrastructure (Fan/Fred, etc) which exists to support the 30-year fixed rate loan.
DeleteHelp me with this question:
Should SECU help a member make a mortgage that is not in the best interest of that individual member, nor in the best interest of the overall SECU membership?
Answer to 9:13, yes, given them the fixed. 9:09, no , of course we shouldn’t. A 30 fixed isn’t against the best interests of members.
Delete9:13.. the problem with the notion of "very often" being the better option is that you have to wait 5 or 10 years whether that turned out to be true.
DeleteThe only thing known at the point of origination is that your ARM payment is lower than the payment you could have gotten on the fixed loan, for 5 years - if you could even quality being underwritten at the higher fixed rate.
What isn't known when you make the product choice, that are important 5 year later:
*The future movement in interest rates
*What my payment may change to
*Your income situation
*Your employment situation
*Growth of home values
11.23am A few obvious oversights:
Delete"The only thing known at point of origination" is not correct from the borrower's perspective...
As the example shows with the ARM borrower, it doesn't matter which way rates move 1) down - ARM borrower "wins", 2) no change - ARM borrower "wins", 3) up - ARM borrower is no worse off for next 15 years.
The ARM (and fixed rate!) borrower does know exactly what the maximum principle and interest payment will be.
As to income situation, employment, growth in home values those "credit risks" all applyequally to any mortgage loan. Underwriting standards should be the same for all mortgages.
11:45. Your whole example is flawed, and you're just making numbers up. Easy to just make numbers up and then declare an ARM is better in all scenarios. You use a 2% increase, while market rates have increased 4 basis points in 4-5 years.
DeleteIf ARMs are bad for borrowers in a rising rate environment, then why would SECU offer them to borrowers in a rising rate environment?
Delete1:39pm Interesting question.
DeleteHow do you determine when we are in a rising rate environment?
Are we in one now?
2:29.. well, if market rates are going up, that's a pretty good indication you're in a rising rate environment. If you are in the beginning of fed tightening cycle, that's a pretty good indication mortgage market rates may rise (although mortgage market rates don't always move the same direction as the fed changes.)
Delete3:26pm Some folks might say that is not a very astute answer! Probably because I asked the question poorly.
DeleteMaybe the better questions are:
1) How do you know when a "rising rate" environment is beginning (or a "declining rate" environment is ending )?
2) Which environment are we in now?
1:29. Good question. The nuance is not necessarily rising rate environment, rather what makes the most sense in low and high-rate environments.
Delete3:37pm So like above, if you believe what you say, are we now in a "low rate environment" or a "high rate environment"?
DeleteAlso can you say what the rate range is on a "low rate environment" and the rate range is on a "high rate environment"?
So we'll all know.
12:20 pm Guess you're right that an example is just that - an example, but the example is accurate.
DeleteYou're missing a key element of the 5-year ARM... "the 2% increase" is the maximum , worst case (could be less!) the rate can go up at each 5 year adjustment period .
If you're accurate about the negligible change (only 4 basis points) in rates over the last 4-5 years, then you make a good case for the 5-year ARM.
At the end of the first 5 years, both the fixed rate/ARM borrowers will continue at the same rate as 5 years ago (6.25% for the fixed borrower and 4.25% for the ARM )
The ARM borrower has now paid $22,260 less in interest [link] than the fixed rate borrower; and, will gain another $22,260 over the next 5 years - regardless of how rates move. Saving @$45,000 on their mortgae is a pretty good deal for most folks.
Well, for whatever trap you are trying to lay, you may know there is no universally known or defined rate change for high and low rate environments.
Delete8:28pm No, I knew that, but just wanted you to acknowledge that the idea that LA gurus knew when we're in a rising or declining market is a completely silly idea and response.
DeleteNo trap, but thank you for stepping up.
Since you went there, it’s easy for anyone to determine if we are in a rising or declining environment based on whether rates are actually moving up and down. So LA knows that, and so does anyone in the free world that tracks rates. It’s less clear or defined what constitutes the definition of being in a high or low rate environment. You can be in a high rate environment that has decling, rising or flat rates.
DeleteThe only relevant point is that when someone takes out an ARM, no one, including LA, can constantly correctly predict what will happen with rates the day after an ARM is booked, let alone what the rate will be 5 years later when it resets.
"Don't fight the Fed"
ReplyDeleteOne major flaw in you example is that ARM and Fixed rates don't have a 2% differential. I know you picked that to mask the impact of the rising rate scenario, but it's false and misleading. Instead of making up scenarios, why don't we use actuals?
ReplyDeleteYesterday, SECU offered a 5.25% rate on 5 year ARM, $300k loan on a home in wake county. The fixed rate option was 6.15%, a .875% difference.
Following your math... The ARM payment of $1,656 is lower than the fixed payment of 1,822. This is a difference of $166 which translates into $9,960 over 60 months. So in a flash, the $22k we're so excited about just dropped by over half.
Guess what else happened? With a spread of only .875%, the likelihood that an arm rate reset would be higher than the original fixed rate just skyrocketed.
Now, lets look at an example from a 2020 loan, with a fixed rate of 3.875% and an ARM rate of 3%. The ARM payment is $1,264, the fixed payment is $1,410. That generates an $8,753 favorable difference for the ARM. Fast forward to 2025, when rates have gone up very sharply. My ARM resets and 2% cap kicks in. My new rate is 5% and my new payment is $1,740.34, $476 higher than my original payment, and $330 higher than the fixed payment I could have had. If I can even afford that new payment, in years 6-10 I will pay $19,777 more for the ARM than the fixed loan. The 8,753 I saved in years 1-5 is not only gone, through year ten, the ARM has cost me $11,024.
Mr. Blaine paints the ARM as a win in every scenario. How many folks do you know that can afford an overnight increase of $476 in their house payment? That's a real life scenario. We have over $1 billion in delinquent ARM's to show for it.
In 2020, in one of the lowest rate environments on record, we originated $4.5 billion in mortgages, $3 billion, 66% were in ARM loans headed straight into a rising rate environment. The industry originated about 95% fixed.
Can someone explain to me, or better yet, explain to the members struggling to keep up with their house payments, how that was in their best interests?
Can you ask them how many correctly predicted and budget for what their house payment was going to increase to?
The problem has been compounded by huge increases in both property taxes and home insurance since Covid. Obviously this is not unique to ARMs, but at least the fixed rate folks only had to deal with increased ML payments from those factors and not also the increase in interest rates.
DeleteMic drop.
DeleteSo only ARM mortgages should be offered to SECU members? That is what you are stating?
ReplyDelete1:05pm Great question. See next post
ReplyDeletePoint is when you put a member in an ARM in a very low rate environment, odds are way higher rates will go up from that point than that they will go down from that point, and we shouldn't be putting members in that position.
ReplyDeleteThat is my situation. 7 years ago when rates were at the lowest, I got a 5 yr ARM. With the discounted initial rate, there was no way my rate would remain the same or drop. Nevertheless, I bought a fixer upper, made a decent down payment and made some principal payments during 1st five years. When the rate was adjusted (full 2%), the payment increased but not as much because I had reduced the balance. To me, this flexibility with an ARM can be beneficial for some homeowners. So, yes, its good for 10 years. But honestly, if the rate jumps 2% again at my 10th year, I will certainly be considering all options. -c
DeleteOne major flaw in you example is that ARM and Fixed rates don't have a 2% differential.
ReplyDeleteYesterday, SECU offered a 5.25% rate on 5 year ARM, $300k loan on a home in wake county. The fixed rate option was 6.15%, a .875% difference.
8:39pm Can't help it that you are mis-pricing your ARMs and overcharging SECU member borrowers.
DeleteYou could readily be charging 4.15% on your ARM, couldn't you.
Your loan-to-deposit ratio has stalled and is now falling. You're aware you're not meeting your Board approved strategic lending goal, aren't you? (Does it matter?)
Understand you're preparing to compound your problem by adding race-based lending (RBL) to mortgages. You're on a roll!
So you think we should lose money on every new arm loan and make all the other members subsidize it?
DeleteSure.. we’re paying over 4% on cd’s charge 4% on loans. Let’s just give them away. Free toaster with it?
Deleteover charging and under paying the new/new ...
Deletebut hey 'most profitable year ever' ...
So ridiculous. How long are you going to keep bringing that up? We’re the least profitable among the largest credit unions because of our dividend expense.
DeleteEveryone acts like a lender can significantly undercut market rates by significant amounts. I would think there would be rules in place to prevent lenders from doing such a thing in order to maintain market stability and reduce tax avoidance. Don’t you think its odd you never see mortgage lenders significantly undercutting market rates to gain market share (ie the amazon strategy)?
Delete9:27pm Are you losing money on every ARM loan you make?
DeleteHow are all members subsidizing ARM borrowers? How so?
9:58am Don't forget SECU members are being paid just 2% on MMSA balances of $17 billion, .25% on share balances of $7 billion , 3% on IRAs of $3 billion and .15% on checking balances of $7 billion.
ReplyDeleteIf you average all that together you're paying members only @1.3% on $34 billion of the $45 billion of their money you manage.
Not exactly a "4%" return...what kind of toaster were you suggesting?
Dividends as is Stock dividends? Who knew ...
DeleteI really need to catch up with this new/new cu ....