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Up in ARMs


Reading Fleck's piece this morning reminded me of Mr. Greenspan's recommendation that prospective home buyers should employ ARMs (adjustable rate mortgages) in financing their house. This advice is synonymous with jumping off a building to blow-dry your hair.

We all know that when buying a home, most people simply figure out "how much house they can afford" and pick the best one from that price range. The price range is consequently the maximum amount the home owner can afford and is determined by how much they have to put down in equity and how much their monthly payments are.

The average down payment (equity) today is the lowest in history. With that hurdle out of the way, the all important variable becomes the monthly payment.

A thirty year fixed mortgage today is around 5.7%. A $250,000 mortgage would require a $1,450 monthly payment.

A thirty year ARM, adjustable after one-year, starts out at 1.95%. A $250,000 mortgage would initially require a $925 monthly payment. If rates rise, after one year the mortgage holder has the right to raise the monthly payment reflective of market rates.

If home buyers base the affordable price range of a house based on a monthly payment as required by an ARM, they are likely to buy much more house than they can afford given the risk that rates will rise in the future. We all know that this is likely given the nature of people.

The Fed knows this too. They want to get the most possible out of their stimulus. This requires getting the consumer to take the most risk possible.

Of course the Fed won't be there to offer advice to the home owner after rates rise and these homes are foreclosed.

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