Counterintuitive thought about mortgages

[Puppycow]

Which is riskier, a fixed rate mortgage or an adjustable rate mortgage? (For purposes of this discussion, I mean just a regular adjustable-rate mortgage without a so-called "teaser rate")

Most people think of a fixed rate mortgage as safer, but is this really true?
For one thing, you pay premium for a fixed rate mortgage. The premium is thought to be the price for transferring the interest rate risk to the lender.

Interest rates go up when inflation expectations go up, but inflation has the simultaneous effect of reducing the real value of debt principal. And when there is general inflation, then average wages should also inflate at roughly the same pace, right?

Putting it another way, a fixed rate mortgage is a bet that the weighted average interest rate over the life of the loan will be higher than the current market adjustable rate plus the interest rate risk premium. I'm guessing that's a bet that the house will win much more often than the customer.

Some people might say that, well, at least the worst case scenario is worse in the case of an adjustable rate mortgage. I wonder if this is really true. Default is one worst-case scenario, and I'm not at all sure that likelihood is really higher for adjustable rates than for fixed rates (assuming that the same person is buying the same house for the same price; all bets are off in case of a so-called "liars' loan," "NINJA loan" (NINJA: No Income, No Job, no Assets) or a "teaser rate mortgage" where someone buys much more house than they can reasonably expect to afford).

Another worst-case scenario is the theoretical total cost of the loan. In case of the fixed-rate loan, there is a nominal upper limit to the total cost. In fact the total cost is fixed on a nominal basis. However, the real cost depends on inflation (or deflation). Therefore, it's not clear to me that the worst-case scenario in terms of real cost is higher for the adjustable-rate mortgage.

IOW, with a fixed rate mortgage, the nominal cost is fixed, but the real cost is anything but fixed. OTOH, with an adjustable-rate mortgage, the nominal cost is not fixed, but the real cost may actually be closer to being fixed (on a real basis) than with a fixed rate mortgage.

 

[Aepervius]

Well , fixed rate are no bet. You know what you will pay, you know how much you bring in. And barring losing job/health problem for which both fixed and variable rate have the same risk, variable rate is a bet on various parameter independant of the loan itself. Bet are risky by nature, even if the risk is low. So yeah variable are are ALWAYS more risky than fixed rate. AT least for the one taking the loan. Now what you could argue is whether fixed rate are less expansive than variable rate.

 

[drkitten]

Which is riskier, a fixed rate mortgage or an adjustable rate mortgage? (For purposes of this discussion, I mean just a regular adjustable-rate mortgage without a so-called "teaser rate")

An adjustable-rate mortgage, by any normal definition of risk.

Most people think of a fixed rate mortgage as safer, but is this really true?

Yes.

For one thing, you pay premium for a fixed rate mortgage. The premium is thought to be the price for transferring the interest rate risk to the lender.

That's right.

Interest rates go up when inflation expectations go up, but inflation has the simultaneous effect of reducing the real value of debt principal. And when there is general inflation, then average wages should also inflate at roughly the same pace, right?

Not always. That's why it's a "risk."

A risk isn't a probability of a negative consequence; that's why phrases like "upside risk" aren't meaningless. A risk is an uncertainty.

Since the amount of interest and therefore the payment due is fixed on a fixed-rate mortgage, it's less "risky" than an ARM. In theory at least, the lender did DD and has a reasonable expectation that the buyer can pay it off over the length of the loan. There is no way for that same lender to have the same degree of confidence with an ARM, precisely because he doesn't know what the payment will be over time.

 

[Professor Yaffle]

Well we got a 5 year fixed rate and have had stable payments throughout a time when they shot up quite high and then went down really low. Although at the moment we are paying more than we would if we had a variable rate, I am definitely happy with the decision we made.

 

[Ron Swanson]

We recently dropped our mortgage all together, opting for a standard line of credit.

The way the intertest payments are handled, with the same payment level, it can be payed off vastly faster ... AND the minimum payment required drops every month.

If we have an fananicial difficulties the line of credit will self pay the interest only for months if needed.

It's variable rate interest.

 

[The Central Scrutinizer]

Which is riskier, a fixed rate mortgage or an adjustable rate mortgage?

Which is better - steak or lobster?

In other words, there is no correct answer.

 

[Puppycow]

Which is better - steak or lobster?

In other words, there is no correct answer.

Steak is better.

 

[Puppycow]

Well we got a 5 year fixed rate and have had stable payments throughout a time when they shot up quite high and then went down really low. Although at the moment we are paying more than we would if we had a variable rate, I am definitely happy with the decision we made.

I have to admit that in practice I too have opted for fixed rates each time I had the option to choose. I started on a 5 year fixed rate and when that ended I refinanced with another bank and chose a 10-year fixed rate that they were flogging. 1.9% interest (but there's some up-front fees and you have to pay a guarantee company to guarantee the mortgage for the bank too). Still, I'm saving money because my old bank was going to jack up the interest after the first 5 years.

BTW, interest rates in Japan have been near 0 for almost a decade I think. I probably would have payed less with a variable rate so far.

 

[Puppycow]

Excerpt from a speech by Alan Greenspan

One way homeowners attempt to manage their payment risk is to use fixed-rate mortgages, which typically allow homeowners to prepay their debt when interest rates fall but do not involve an increase in payments when interest rates rise. Homeowners pay a lot of money for the right to refinance and for the insurance against increasing mortgage payments. Calculations by market analysts of the "option adjusted spread" on mortgages suggest that the cost of these benefits conferred by fixed-rate mortgages can range from 0.5 percent to 1.2 percent, raising homeowners' annual after-tax mortgage payments by several thousand dollars. Indeed, recent research within the Federal Reserve suggests that many homeowners might have saved tens of thousands of dollars had they held adjustable-rate mortgages rather than fixed-rate mortgages during the past decade, though this would not have been the case, of course, had interest rates trended sharply upward.

American homeowners clearly like the certainty of fixed mortgage payments. This preference is in striking contrast to the situation in some other countries, where adjustable-rate mortgages are far more common and where efforts to introduce American-type fixed-rate mortgages generally have not been successful. Fixed-rate mortgages seem unduly expensive to households in other countries. One possible reason is that these mortgages effectively charge homeowners high fees for protection against rising interest rates and for the right to refinance.

American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage. To the degree that households are driven by fears of payment shocks but are willing to manage their own interest rate risks, the traditional fixed-rate mortgage may be an expensive method of financing a home.

So far I haven't seen anyone address my point that with a fixed-rate mortgage, the nominal cost is fixed, but not the real cost, which will depend on inflation and/or deflation of the currency over the life of the loan.

 

[egslim]

Of course an adjustable mortgage will be cheaper, on average. With a fixed mortgage you basically pay an insurance premium to tranfer the risk of increased inflation to the lender. As usual, the reason to buy insurance against an event is if you can't afford to take the risk, specifically, can't afford the potential loss.

So far I haven't seen anyone address my point that with a fixed-rate mortgage, the nominal cost is fixed, but not the real cost, which will depend on inflation and/or deflation of the currency over the life of the loan.

Except deflation is relatively rare, usually maxes out in the low single digits, and with the Fed's fondness of low interest rates and quantitative easing is unlikely to be a major issue in the US.
While inflation is much more common, and only 30 years ago in the US peaked at over 10%. The inflation/deflation rate is currently at the low end of what's realistically possible.

But more importantly, your salary is also set at a nominal value. So even if a hypothetical high rate of deflation causes the real cost of your fixed mortgage to increase, the real value of your salary increases by the same amount, and your ability to pay won't be in jeopardy.

Fixed mortgage = higher cost, lower risk.

 

[Puppycow]

But more importantly, your salary is also set at a nominal value. So even if a hypothetical high rate of deflation causes the real cost of your fixed mortgage to increase, the real value of your salary increases by the same amount, and your ability to pay won't be in jeopardy.

Fixed mortgage = higher cost, lower risk.

But salaries are not fixed. Most people get a raise each year roughly in line with inflation. It's much harder to give raises when there is deflation. If you aren't getting a raise that keeps up with inflation, you are getting, in effect, a pay cut. The last time we had high inflation, my understanding is that it was driven by wage inflation.

 

[egslim]

But salaries are not fixed. Most people get a raise each year roughly in line with inflation. It's much harder to give raises when there is deflation. If you aren't getting a raise that keeps up with inflation, you are getting, in effect, a pay cut. The last time we had high inflation, my understanding is that it was driven by wage inflation.

I don't see the problem.

In case of increased inflation, your salary either stays the same or goes up in nominal terms.
- Your fixed mortgage also stays the same nominally, so you continue to be able to afford it as a percentage of your income - the percentage is reduced.
- Your ARM increases nominally, if it does so much faster than your salary, you have a problem.
Of course if your other expenses increase faster than your salary does, then even the fixed mortgage may eventually pose a problem, but the ARM will be much worse.

In case of deflation your salary is most likely to stay the same in nominal terms. That's because nominal paycuts piss off most people much more than inflationary cuts.
- Your fixed mortgage increases in real terms, but since your salary does so by the same proportion, you continue to be able to afford it.

Either way you're fine with a fixed mortgage. The ARM is much cheaper in case of deflation, but may get unaffordably expensive with high inflation.

The way I see it, your line of reasoning implicitely makes two false assumptions:
1) Inflation and deflation are symmetric.
They're not. Deflation is relatively rare, and only occurs in low, single digit numbers. Inflation is much more common, and may occasionally jump to incredible heights.
2) That people care more about a real change in salary than a nominal one.
Mathematically they should, but reality is different. The vast majority feels better about a 2% rise when there's 5% inflation, than about a 2% cut when there's 5% deflation. That's because inflation is more abstract, while the number of the paycheck is to most people more real.

Even if inflation is wage-driven, that doesn't mean all wages simultaneously increase by the same ratio. Many stay behind the curve, and they get hit hard by the inflation that outpaces them.

 

[drkitten]

nominal[/B] cost is fixed, but not the real cost, which will depend on inflation and/or deflation of the currency over the life of the loan.

Post #3.

Interest rates and inflation correlate, but do not move in lock-step (in part because interest rates depend not only on how well you do, but how well everyone else is doing). Therefore, not only will the nominal cost vary, but so will the real cost.

So a fixed-rate mortgage has a fixed nominal cost but a variable real cost. A variable-rate mortgage has both a variable nominal cost and a variable real cost.

A variable-rate mortgage is therefore inherently riskier.

 

[pgwenthold]

How often throughout history has there been net deflation in a 30 year period? It may have happened, but I would suggest that inflation is much, much more likely.

In that case, whereas the fixed rate mortgage does have a variable real cost, it almost invariably gets cheaper.

 

[drkitten]

How often throughout history has there been net deflation in a 30 year period?

Not especially relevant if you're planning on moving in the next thirty years. If mortgages were only for people who planned to pay them off in full over time, very few professionals would have mortgages.

 

[Brainster]

There is no denying that a variable rate is riskier. By definition, variance = risk. Now, that's not to say that variable rates are bad; I've had a variable rate on my home for years and it's definitely saved me money compared to what I would have paid on a fixed-rate loan at the time, although I'm sure that I could locate a point in time when I could have switched over to a fixed rate and saved even more.

 

[blutoski]

How often throughout history has there been net deflation in a 30 year period? It may have happened, but I would suggest that inflation is much, much more likely.

I think you're confusing nonzero interest rates with consistently rising interest rates. It is true that inflation is likely to be perennial, but extremely unlikely that inflation rates will rise consistently. In this post-eighties world, most countries have a national fiscal policy of maintaining control over inflation.

I can't say governments have the same attitude about lending rates.

Real estate has (arguably) been a good investment over time because the inflation of real estate prices is greater than the overall inflation rate, and in particular, greater than growth in real wages. I'm not sure why.

 

[drkitten]

Real estate has (arguably) been a good investment over time because the inflation of real estate prices is greater than the overall inflation rate, and in particular, greater than growth in real wages. I'm not sure why.

Population growth, IMHO.

The growth of population creates a greater demand for housing and for ancillary services that also require real estate -- like churches, schools, hospitals, police stations, strip malls, restaurants,....

This also explains why inflation in real estate prices tends to be greater in metropolitan areas; cities have been growing in population faster than farmland. Indeed, some of the greatest such price increases happen when farmland is turned into a city (as in Orlando, FL).

 

[blutoski]

Also:

I did my recent mortgage as a portion fixed and another portion variable. Part of the reason was to mitigate the risk of variable, but there were other factors. (Specifically, the nature of the variable product was that I could do unlimited balloon payments without service charges.)

 

[oggiesnr]

Another part of the eqation is what the value of your property is going to be, what your credit rating will be and what deals are on offer when your fix expires.

Steve