About a month ago, Alan Greenspan spoke at a Credit Union National Association meeting. He has spoken at many events in the past few months, but this one was particularly memorable, as it launched a heated debate about the merits and demerits of adjustable-rate mortgages (ARMs). What he said in that speech was, basically, over the past decade, people could have saved thousands a year with ARMs as opposed to fixed-rate mortgages.
While certainly fact, it was also fodder for a flurry of protestations regarding the hazards of ARMs. Since that speech, there has been a great deal of alarmism surrounding the problems this country faces should interest rates rise dramatically. Other critics have been more moderate, pointing out the very real possibility that some homeowners could get themselves in a bind should rates make a significant jump.
One of the most outspoken critics of Mr. Greenspan's defense of ARMs has been Suze Orman, who wrote an article entitled "Alan Greenspan's Call to ARMs Could Put You in Great Financial Danger." The article warns investors about the hazards of getting in too deep with ARMs. It illustrates how an ARM payment could nearly double that of a fixed mortgage if interest rates rise dramatically. And that, indeed, is a fact.
But there's more to it than that.
I don't believe things are going to fall apart if rates make a sudden rise. There's no doubt that a rapid rate increase would cut into disposable income and consumer spending. But only one in five mortgages is an ARM. And while ARMs make up about 20% of all U.S. mortgages, they make up a much larger percentage of the total dollars loaned -- nearly 30%. Why? Because most ARMs tend to be for jumbo loans of more than $300,000. In other words, they're loans to people who can afford them -- people who tend to have a lot of disposable income and whose salaries can vary a great deal each year with job changes, pay raises, and bonuses.
Given that most ARMs generally have caps allowing them to increase by only 1% or 2% a year, and given that a mortgage only accounts for about one-third of the average household's total income, it doesn't take much of a pay increase to compensate for the rate hike. Additionally, since rates only change once a year at most, and since many ARMs don't change at all in the first several years, people generally have quite a bit of warning to do something about rising rates.
All that said, people do need to be careful about overextending themselves. Particularly for people on relatively fixed incomes, ARMs are probably not the best solution. We have a handy calculator in our Home Center that makes it easy to compare payment amounts at different rates to see what an ARM could cost you if rates go up.
With rates at historical lows, there's no doubt that they will eventually go up. For people who can afford the potential payment increase, there's also no guarantee that rates will rise to a high level for a lengthy period of time. And ARMs have a lifetime rate increase cap of around 6%, so there's no reason for not knowing the most you could have to pay.
Over the lifetime of an ARM, there's a good chance you're going to save a lot of money. Here's why: Lenders charge higher interest rates on fixed mortgages because they shoulder the risk that rates will rise later. However, if you take on that risk -- and you know the limits of that risk -- you may be saving some of the risk premium you would otherwise be paying to the lender.
Our Home Center offers all sorts of handy, dandy information on buying and maintaining a home. Still haven't refinanced? First-time homebuyer? Don't move a muscle without checking out our Home Center first.
Fool contributor Mark Mahorney doesn't own shares of any companies mentioned.