While the interest rates on Adjustable Rate Mortgages can be lower than fixed rates, the risks you are taking, in my opinion, are far too great.
It happened fairly recently. During a boom time, housing prices started to skyrocket, due in part to declining interest rates and a booming economy. People started buying larger and fancier houses, often buying "as much house as they could afford" and leveraging this even further by using novel mortgage instruments, such as variable rate (ARM) loans and even interest-only loans.
Then, a few years later, it all collapsed, and people ended up "upside down" on their homes and the interest rate on their ARMs escalated, and they ended up in foreclosure and lost it all.
The Real Estate Bubble of 2008? Well, yes, but I was thinking of the Bubble of 1989.
Funny thing, but 20 years ago, the same things happened as did today, and no one learned the lesson.
Well, not no one. I did. After seeing friends literally crying about losing their houses, or having to bring $10,000 to $20,000 to the closing table to sell a house, I thought to myself, "Never, ever, get into one of these Adjustable-rate flim-flams."
Why are ARMs such a bad deal? Why will your Real Estate Agent or Mortgage Broker tell you than I am chock full of shit on this one? Let's review these one at a time.
In a traditional Real Estate market, people buy and sell homes either as places to live for themselves, or to rent them out at a profit - not to buy and flip, which is a sure sign of a bubble market. In a traditional market, which is what we are seeing now and will see for the next decade or more, housing will increase in value only slowly - perhaps 2-5% a year, if that (declining population growth spells stagnation for this sector - still sure you are against Immigration?).
As such, in order to break even on a home sale - just to cover the closing costs, taxes, Real Estate Agent fees, bank points, etc., you have to hold a home for 5 years or more. Buying a home is a long-term investment, not a short-term deal. If you are not going to stay in a home for five years or more, renting is probably cheaper and easier, as the transaction costs of buying and selling will dwarf any savings or tax incentives. In addition, it is far less riskier.
If you are going to stay in a home for more than five years, it makes sense to have a loan that is fixed for more than five years. Otherwise, you may find yourself "priced out" of the home. And once interest rates go up, housing prices go down - they are like Ying and Yang in that regard. So not only is the scenario of ending up with a mortgage payment you can't afford on a house you can't sell (or refinance) possible, it is inevitable should interest rates rise. And in that scenario, the idea touted by the Real Estate Agent, that you can "simply refinance" is just a fantasy.
If interest rates go down, you can always refinance your fixed mortgage, of course, and the savings in monthly payment will usually pay for the transaction costs within a year or two. So there is little "danger" in getting a 30-year fixed note of being "locked in" to a high rate.
So why do Real Estate Agents and Mortgage Brokers push the ARMs? Because it sells houses and sells mortgages. A Real Estate Agent knows that you can't afford that mini-mansion on a 30-year fixed note, so they push you to "buy more house" ("as much as you can afford!" - a bad idea!) using complicated financial instruments.
" The more complicated you can make any financial transaction, the easier it is to rip off a consumer" --Robert Bell
So ARMs are a bad idea all around, except for the Real Estate Agent, who gets a commission on a house that you otherwise would not buy and the Mortgage Broker gets a commission as well. And the more they can push these oddball loans, the more money people will spend on homes, as the "monthly payment" is the same - or so they think, until the ARM kicks in.
And as we have noted here in the past, when "funny money" predominates, markets go berserk. Colleges and Universities have been raising tuition at 2-3 times the rate of inflation simply because it is so easy to get naive 18-year-olds to sign their lives away in student loans.
I know it sounds stupid, but your average Joe or Josephine has this mental disconnect between borrowing money and paying it back. They assume someone else (the future them) will have to pay it back.
If you are thinking of buying a home - and there are some reasonable bargains out there right now in some communities - look at a 30-year fixed-rate note or even a 15- or 20-year fixed rate. It is the safest bet around, and if your income goes up over time, the "excess" money you are making can be used to pay down the debt, or to invest for your retirement - both actions which will increase your net worth.
The ARM, on the other hand, is a sure gamble, as if it all goes horribly wrong (which it often does) not only will you not build up equity, you may end up bankrupt. Is bankruptcy (due to interest rate changes, which are not within your control) really worth risking your entire estate? I think not.
If you can't afford a 30-year fixed-rate mortgage on a home, then you are looking at too much home for your income range. Period. Don't be talked in to bad deals by Real Estate Agents who may suggest ARMs. In fact, if the Agent you are talking to suggests such a thing - and pushes you into it - walk away until you find an Agent who is on your side, not the side of the lenders.
Oh, yes, the dirty little secret of the Real Estate Agency business - Agents are constantly wooed by mortgage brokers and closing companies, with cocktail parties, dinners at restaurants, and even cruises and vacations (disguised as "business meetings" to discuss the latest "products" in the mortgage business). Many Agents are sleeping with (sometimes literally, well, actually a lot of times literally) Mortgage Brokers or Closing Companies. And yea, it is a blatant violation of the law of Agency.
Don't act so shocked....This is America!
UPDATE: January 26, 2010. Another reason to eschew an ARM is that interest rates today are at historical lows and will probably go up in the next 5-10 years. If you finance on an ARM today, you might save a paltry amount on interest, but you are basically guaranteed a rate increase in the next five years. And once interest rates rise, you can't lock in on a lower rate, can you?
On the other hand, if you get a fixed mortgage, and rates go down, you can refinance to take advantage of them. With an ARM, it is a lose-lose situation for the homeowner.
If you "can't afford" the house without resorting to funny financing like an ARM, then you can't afford the house, period. Buy a smaller house, or just rent. Bankrupting yourself to own a home makes no sense at all.
Note that for commercial loans, such as I had on my Office and Investment Properties, most banks insist on variable rate instruments - and even "callable notes". These are very risky propositions for people willing to take huge risks. One reason I sold out of the Real Estate market when I did was that these callable notes made me nervous as hell, and when I would sell out at a profit and walk away from that ulcer, I did.
I can't imagine having such financing on my primary residence. Life is too short for that kind of stress.