Allotted only about 10 minutes to share his vision, Mr. Lawler....first made the obligatory statement that he was expressing his own views and not those of his federal agency. Yeah, right, I thought, and reached for my triple espresso.
But then Mr. Lawler launched a frontal assault on the most sacred element in U.S. housing-policy dogma: the 30-year fixed-rate mortgage loan, providing the right to refinance at any time, with no prepayment penalty. If more members of the audience had been fully awake at this moment, I feel sure that their gasps would have been audible.
Now, Americans are very attached to their 30-year fixed-rate freely prepayable mortgages. They like not having to fuss about the possibility of 28% interest rates in 2032, even though most of us will move or die long before then. They love to refinance every time rates drop and then brag to their neighbors about how much they are saving per month.
What they don’t stop to realize often enough is that they are paying a very large price for that privilege– twice.
The context is important. One of the reasons the 30 year fixed rate mortgage is ubiquitous is the United States may be the existence of Fannie and Freddie. If we do away with FF, we may also do away with the 30-year fixed rate mortgage. So let me defend the 30-year fixed a bit with something I wrote about 3 years ago:
The problem with advising people to use adjustable rate mortgages, however, is that ARMs give households liabilities that have short duration--that is, liabilities whose market value remains close to face value at all times. This is because the rates on ARMs by definition change to meet market rates on a regular basis. Houses, on the other hand, are assets with lots of duration. The services they give to homeowners (shelter and a set of amenities) is pretty much invariant to market conditions. Consequently, house values change with market conditions, such as changing interest rates.
Good financial management practice suggests that to minimize risk, the duration of of assets and liabilities for any institution, including households, should be matched. In the case of houses, this means that households looking to minimize risk should use a fixed rate mortgage to finance their house. There are exceptions--if one buys a house and expects to sell it in five years, a five year ARM makes lots of sense, because the duration of the asset (housing services over five years) and the liability would match.
This is not to say there is anything wrong per se with people getting ARMS, so long as they explicitly understand the risk embedded in them. But a principle I have been pushing for years is that if people can't afford a house with a fixed-rate mortgage, they probably shouldn't buy a house. It is one thing to have the option of the FRM, and then decide to take the risk of the ARM anyway. One of the nice things about the United States is that FRMs are easy to come by--this is not true in most countries around the world. It is something else to be forced into taking a risk in order to buy. Under these circumstances, buying probably isn't worth it.
This is too limited a presentation of mismatch for households. With a fixed rate mortgage, your payment will not go up over the entire lifetime of the mortgage. To have truly matched streams, you have to look at the other side.
Is it a realistic assumption that the income side of the mortgage finance decision will not change in thirty years? Wouldn't it be more realistic to assume that incomes will go up at, well, about the rate of inflation?
Yes, there is some risk involved, and to cover that risk has a price. Is paying that difference worthwhile?
Apart from specific risk (job loss, etc), the real inflation risk/finance risk for most will be payment shock during periods where prevailing rates jump over income growth. Almost by definition (income growth basically is inflation), over reasonable time periods this risk is small.
This risk can easily and cheaply be dealt with any number of ways, the simplest of which is a hybrid ARM with, say, a five-year fixed period that can be refixed periodically.
If you already have perfect credit with high scores, this isn’t much of an issue. However, if your scores are lower, or if you’re trying to rebuild credit, it is very highly recommended that you maintain a consistent payment history with no breaks. How can you do this without getting yourself into a mess of debt? You can put an inexpensive magazine subscription on your credit card, for example. That way, you never need to carry the card around, and it’s automatically charged for your subscription amount. Just make sure that you pay it off every month on time.
Well the better your credit scores the better your terms on a credit card. Credit Scores are very important.
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