Adjustable Rate Mortgages and You

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Low real estate prices, and low interest rates will spur growth in the real estate market. This is the general outlook amongst academic and armchair economists alike in India. A similar economic environment existed circa 2013 in the United States. This environment did fuel the start of a housing resurgence, but with it came the inevitable offering of a plethora of mortgage options. This write up is a cautionary tale about Adjustable Rate Mortgage (ARM) offerings that are prevalent in the United States, their contribution to the Great Recession, and why the prevailing economic environment in India may give rise to hybrid mortgages in her real estate market place.

An ARM is a mortgage product, where the interest applied to the outstanding balance of a loan varies over the life of the loan. There are different types of ARM’s, like variable rate loans that are tied to a benchmark Index; interest only loans; and the ones that offer a teaser rate. The latter were really popular during the recent past prior to the Great Recession. These loans are structured with an initial Fixed Interest Rate, typically called a Teaser Rate that is in place for a certain period of time. After the initial Fixed Period the rate changes based on an Index Rate and a possible spread to the Index rate. The index based rate resets over an Adjustment Term. An example would be a 15 year 3/1 ARM. This 15 year loan will be structured with an initial Fixed Interest Rate for the first 3 years, and the interest rate will reset every year (indicated by the 1) thereafter, over the remaining 12 years of the loan.

ARM’s are not as prominent as they were in their heyday prior to the Great Recession, but they are becoming available options. The historical average for buyers choosing ARM’s over conventional mortgages is 25-30%, but it’s approximately 10-15% in the period 2008-2014. The turn of the century witnessed an increase in new mortgage products, including many that allowed borrowers who could not meet traditional underwriting standards to obtain home mortgages and achieve home ownership. Nearly half of the sub-prime loans originated between 1999 and 2009 were ARM loans. Penington-Cross and Ho (2010) specifically examine the performance of hybrid and adjustable rate loans. At rate reset, these mortgages were refinanced till the time the home prices were rising from 2001 to 2004. But, as house prices started to stabilize in 2007, and ultimately fall by 2008, only the borrowers with excellent credit history and deep pockets could refinance. Large payment shocks were experienced with hybrid loans, and the only remaining option for many subprime borrowers was to default on their loans.

As conventional fixed rate mortgage rates bottomed out in early 2013, and home prices started to recover, the ARM loans started to make a comeback. Home prices are going up, and some see the low introductory teaser rate as their way to qualify for a mortgage, and thereby home ownership. Mr. Lawrence Yun, a contributor to Forbes with an interest in developments in the real estate market, states that nationwide home prices have risen by 10% over the past two years. The home prices are rising 3 to 4 times as fast as the national average wage growth rate. Overall credit conditions appear to be loosening. The average credit score for mortgages that were approved in January, 2016 was 719, compared to 730 to 740 range for all of 2015. So, rising home prices, rising conventional mortgage rates, and easier credit conditions are fueling the appetite for ARM’s with low teaser rates. If economic predictions hold true, this ‘not yet a bubble’ environment will come to India’s doorstep within the next five years, as Real Estate Regulation and Development Act (RERA) gets implemented by the states, consumer confidence increases due to transparency, and consumers get access to easy credit.

But, a word of caution, an ARM is not for everyone. It is a risky product. The risk is inherent in the loan structure. The interest rate is not fixed, hence the payment for the loan is not fixed. The interest rate will rise or fall with the underlying index rate after the initial fixed period, and consequently the payment will rise or fall as well. The suitability of an ARM is dependent on many factors. Some of the primary ones are: duration of the holding, i.e. how long does one stay in the house; expectation of price rise; and deep pockets to weather an increase in rates.

As home buyers enter the market, it behooves them to consider all the mortgage options available to them to fulfill their dream of home ownership. Careful evaluation of the hybrid mortgage options like ARM’s and Interest Only loans will lead to a better quality of home ownership, and this will result in a better quality of mortgage loans as well. India needs her own version of the Consumer Financial Protection Bureau. This is an agency of the United States government responsible for consumer protection in the financial sector. It was created in 2010 as part of a legislative response to the financial crises of 2007-08 and the subsequent Great Recession. Through outreach via their website and community programs the organization imparts education and provides homebuyers access to resources that help a homebuyer make an educated mortgage decision. It is also incumbent upon the mortgage originators to explicitly highlight the risks associated with hybrid loans. Shared responsibility in educating the home buyer will go a long way in ensuring that the missteps that led to the Great Recession in the US are not repeated in India.