Thanks, Alan! – Part 2

Last week, we discussed Fed Chairman Alan Greenspan’s observation as to the gazillions of dollars that could have been saved by homeowners had they chosen ARMs in the last ten years instead of fixed rate loans. How do you figure out which choice is right for you?

Of course, the concept of a mortgage payment that could change was and is scary to some people. Rather than trying to overcome their fear by getting more information, they just went with what they were used to. That turned out to have been an expensive mistake. Let’s talk how you can approach this problem.

There is a thing I call the “propensity to accept risk.” Some people go skydiving whereas some people won’t even fly in any kind of an airplane. This applies to the financial aspects of our lives as well. Some people are very happy working on commission, while others need the security of a steady, reliable monthly paycheck. If you are a retired minister, your propensity will be different than if you are a 25 year old stockbroker. To be able to consider alternatives intelligently, you need to determine your propensity to accept risk. Indeed, you will probably find that you have a greater propensity than you first were willing to acknowledge.

The reason it is worthwhile to go through this exercise is that the more risk you are willing to accept, the cheaper your loan will be. So what you need to do is balance the risk and the savings.

You should also understand that there are better versions of the ARM than just the one you first think of, the one that varies every year or every six months. The ones I like best are the so-called “Interim Fixed” ARM’s which are 30-year loans, but fixed for a long introductory period of 3, 5, 7, or 10 years.

The next step is to figure out who long you are likely to be in the home. Sometimes, people are buying a home with the express purpose of fixing it up and selling it in within a year or two. Typical first-time homebuyers might know that their first home is a starter home and they aren’t going to be in it for more than five years. Others might know that this is the last home they will ever own.

Let’s say for the moment that you are thinking that you may be in a home for five years, perhaps six. You can reasonably consider a 5/1 ARM, one that is fixed for five years. Note that it does not have a balloon payment; it just turns into an ARM at whatever the market rates are at that time. The good news is that today that loan is over one percent cheaper than the 30-year fixed rate loan that many people choose without thinking. If you have a $200,000 loan, you are going to save about $2,000 per year or $10,000 over those five years.

So the question you have to answer is, “Will I be happier with $10,000 and taking one year of risk, or would I rather know my mortgage payment won’t change between 2009 and 2034?”

Not infrequently, we find someone who really is buying a home for a long period. In some of those cases, we end up getting those clients fixed rate loans, but only because it was selected after going through the process correctly. I will hasten to add that even among this group, not everyone chose a fixed rate loan. People with a higher propensity to accept risk said, “If I can save that much money, I’ll be very happy to buy my risk protection five years at a time.” During the last twenty years those who did take on that risk almost invariably found that after year three or four years, assuming they were still going to stay in the home, that they could refinance for another five years at a cost of much less than what they saved.

You can see that when you go the process this way, you will get better results than those who have gone about it without much thinking. I think that is exactly what Chairman Greenspan was talking about. He wasn’t just giving a speech, he was talking about what you and every other homeowner in America ought to be considering.

Go through that process, choose carefully, and it will work out well for you and your family.