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Minyan Mailbag: ARM's


Looks can be deceiving!


Note: Our goal in Minyanville is to remove intimidation from the financial markets and encourage an interactive dialogue among the Minyanship. We share this next column with that very intent.

Prof. Succo -

Adjustable rate mortgages are neither inherently good nor bad. It all depends on how you use them.

As a mortgage banker, we have long used adjustable rate mortgages and interest only loans as a financial tool. They comprise 40% of our loan volume. They are an excellent financial planning tool, and can help consumers use the same techniques that banks use to create wealth, and that is arbitrage. We teach our customers to borrow their equity at say 6%, which is tax free, and can also be paid using an interest only payment. Using a 28% federal tax bracket, and a 3% state tax, this means that after taxes their rate is about 4%. They can then use this equity and cash flow to fund a tax preferred instrument like life insurance with a fixed return of 6% tax free, which is like 8% taxable. They are thus using equity or monthly cash flow that was previously earning 0 return, and making the 4% spread. Over time, this can create sizeable wealth. (Sometimes municipal bonds can also be used as the vehicle). If interest rates rise, so does the corresponding return on the savings vehicle, keeping the spread the same.

Therefore, the adjustable loans or interest only loans are not a negative, and don't bring the person closer to bankruptcy, but instead help the consumer grow a side account that grows more quickly than making corresponding principal payments on their mortgage. For most people, their mortgage is their biggest deduction and we want to maximize its tax advantages.

Minyan D

Minyan D -

You are correct that ARMs are not inherently "bad". But this is a very important point. Everyone please listen because this is what is happening...people are doing half of the analysis (as in above) and they see adjustable rate mortgages as a good financial deal because they provide a cheaper form of financing than a fixed-rate mortgage. This is not in dispute, but it is the crux of the problem.

The adjustable rate mortgage in and of itself makes mortgages cheaper: it allows people who could not make the higher mortgage payments associated with a fixed-rate mortgage to buy a house. They encourage an entire group of people who cannot really afford the risk of buying a house, because their income is unstable and/or low, to do so. They are at risk of not being able to keep up with payments once interest rates rise. If they plan on selling the house in a few years they are at risk of the price going down due to an interest rate rise. By bringing in demand like this it is one of the reasons housing prices have gone up. It is credit expansion tapping a previously untapped group of people, a group of people that previously only could rent given their financial status. In reality they are renting with an added risk: possible loss of capital.

It is not the financial terms of the ARM that does the harm. It is the fact that it brings a group of people to take out mortgages that have a high probability of loss.

As for the financially "savvy" people that you describe that are "locking in a risk free return" I think you are giving them bad advice.

First of all your 4% after-tax spread is incorrect: it is really 2%.

Now let's say a person can get a five-year fixed then adjustable mortgage as you say below. If that person's after-tax cost is 4% for five years and then they can invest the proceeds at 6% risk-free that is a great deal. I agree. The problem is that you can't do it, it just seems like you can.

Your example of a life insurance annuity needs to be analyzed better. There is no reputable life insurance company that will borrow money from you (sell you an annuity) for five years and pay 6%. Maybe you can find an Acme Life Insurance Company that will do it, but if they go bankrupt you get nothing (remember, when you buy an annuity or take out a policy from a life insurance company you are essentially lending them money and taking the risk that they won't pay off). Acme Life Insurance Companies go bankrupt all the time.

Let's call up a reputable life insurance company like North Western Mutual. They are AAA rated and sure to pay off. They have products that may look like they pay 6% for five years, but in reality it is not fixed. You can buy a combination of whole-life and term insurance wrapped up where if you analyze your current payments versus when you likely will die it looks like a 6% after-tax return. The problem is at any time the insurance company has the right to raise your premiums. They don't tell you that. In fact they don't even have to tell you when they do it: if you are four years into the payments they actually can go back and say, "Oh by the way, we need to retro-actively raise your premiums by x amount to keep the policy going."

If you don't agree and want out they will only give you back the cash value of the policy, which will be actually below the amount of cash payments you have made. It will be a negative return. Even if they never raise the premiums and you want out after five years (because the fixed portion of the ARM has run out) you will still only receive back the cash value of the policy.

If you can find a 6% after-tax risk free return investment for five years please explain it to me: I have a great deal of my investors' money to put to work. And that is my point...if this were true it would be arbitraged out very quickly by large institutions.

I strongly implore all people to really look at the details before agreeing to deals like this.


Prof. Succo

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