Updated: May 3, 2013 12:14PM
Originally published: March 4, 2004
Don’t follow Alan Greenspan’s advice! The Federal Reserve chairman isn’t supposed to forecast interest rates, but there he was last week, warning home buyers against fixed-rate mortgages and promoting adjustable-rate mortgages to achieve financial “flexibility.” Instead, it’s likely he’s luring many households into financial disaster.
Greenspan can’t promise that interest rates will remain at present, historically low levels, because the Fed chairman can’t control long-term rates. And the Fed chairman is not supposed to be forecasting future interest rates anyway. So why would he lead homeowners into a trap that could cost them plenty of money if long-term interest rates rise in the coming years?
I’ve previously noted in this column that Greenspan doesn’t have a great track record on forecasting markets. It was just a few months ago that he was warning of soaring natural gas prices, just as that market hit its peak, and started to fall. And back on March 6, 2000 -- four days before the all-time peak in the Nasdaq index and the subsequent meltdown -- he was publicly extolling the virtues of the new era in technology.
A record of mistakes
Greenspan has a track record of forecasting mistakes. For instance, in 1990 he said, “I see no recession on the horizon.” That was just before a very tough recession. Also of note, in the early 1970’s, Greenspan went on record as saying there was no reason for gold to trade over $32 an ounce. Gold subsequently soared over $800 an ounce.
Every forecaster makes mistakes. But now Greenspan is advising homeowners to play the interest-rate market by taking on adjustable-rate mortgages. He also stated that he’s not worried about American household balance sheets, in spite of record bankruptcies, because rising real estate prices bolster consumer finances. That’s the logic that produced the stock market bubble.
What if Mr. Greenspan is wrong again? What if interest rates rise? Home values will fall. And the burden of adjustable-rate mortgages will be huge.
There’s nothing inherently wrong with adjustable-rate mortgages, if you’re willing to take the risk. In fact, ARMs now account for about 29 percent of all new mortgages. They’re attractive because they start with significantly lower rates than 30-year fixed-rate mortgages.
Today, with excellent credit, you can get a 30-year fixed-rate mortgage for 5.5 percent and a monthly payment of $567.79 for every $100,000 borrowed.
But an ARM that is fixed for three years, and then adjusts every year thereafter, would have a starting rate of only 3.5 percent, and a monthly payment of only $449.04 for every $100,000 borrowed.
Saving $118.75 per month is very tempting. But remember, after three years, that rate can adjust every year, and that means your monthly payment can change every year. Most lenders have a 1 or 2 percentage point cap on annual increases, and a maximum increase of 5 or 6 percent over the life of the loan. Still, if worse comes to worst and you reach the 6 percent cap in a few years, your monthly payment could jump to $840.85 for every $100,000 borrowed, nearly doubling your monthly payment. Could you afford that?
So here’s a Terry’s Tip when considering adjustable-rate mortgages.
How long will you stay in your home? If you’re planning to move in a few years, then an adjustable-rate mortgage can keep your monthly costs down. But if rates rise sharply, it may not be so easy to sell this home in a few years when you planned.
What’s the adjustment based on? Be sure to ask about the index on which your annual payment change is based. The one- year Treasury index can be very volatile.
How could my payment change? Ask the lender to calculate the maximum amount your payment could increase in a worst-case scenario.
If you understand these risks, you might still opt for an adjustable-rate mortgage. But, if you’re planning to live in this home for many years, or if you want the peace of mind of knowing you’ll have a fixed monthly payment, then stick with a traditional 30-year fixed-rate loan.
Greenspan should know there’s not just one right answer when it comes to making decisions about the most important investment of your life. That’s the Savage Truth.
Terry Savage is a registered investment adviser and is on the board of the Chicago Mercantile Exchange. She appears weekly on WMAQ-Channel 5’s 4:30 p.m. newscast, and can be reached at www.terrysavage.com.