Bad Advice on Mortgages from the NYT

The Sunday Times has an article reporting that many homebuyers who took out adjustable rate mortgages 3 years ago, are now refinancing to avoid higher mortgage rates. The article (actually the accompanying chart) also adds that many are refinancing with negative amortization loans, under which the outstanding principle increases through time. The chart tells readers that this could make sense, as long as house prices continue to rise.

Okay, let's check the numbers here. Three years ago, homeowners were taking out adjustable rate mortgages at rates in the neighborhood of 4.5 percent. Many are now resetting at rates that are 2.0 percentage points higher, or close to 6.5 percent. The article reports that the national average for adjustable rate mortgages is now 6.28 percent. Throw in fees of 0.5 to 1.0 percent and it's hard to find the savings. In other words, simply exchanging adjustable rate mortgages will not in general save homeowners any money.

Now, the point may be that homeowners are pulling more equity out of their home, taking advantage of the strong appreciation in many areas over the last three years. While, contrary to claims in the article, this doesn't save anything in terms of monthly payments (the payment on a larger mortgage will be higher, not lower), the additional cash can postpone a day of reckoning.

However, the risk in this case is really the exact opposite of what the article claims. The article reports that this strategy may make sense if home prices continue to climb. Actually, pulling out more equity can make much more sense if home prices fall. In that case, the mortgage holder is left with a mortgage that exceeds the value of the house. The homeowner can walk away turning over a house that may be worth much less than the amount of money he has borrowed. That might not be pretty, but it is what will happen in hundreds of thousands of cases across the country.

--Dean Baker

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