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Homeowners are taking the risky route and I am confused

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Does anyone else find this weird?

…a one-year ARM, at 5.8 percent on average, now costs only a third of a percentage point less than a 30-year fixed-rate mortgage, at 6.2 percent. And ARM holders still face the risk of paying a higher interest rate down the road.

But while there’s a new refi boom in swing, not all borrowers are rushing for the security of fixed loans. One in three homeowners refinancing today is choosing the financially riskier interest-only and payment-option ARMs, according to data from Loan Performance.

Many who are doing so may have chosen those mortgages not because they want them but because they can’t afford the payments that would come due under a 30-year fixed rate, said Keith Gumbinger, HSH’s vice president.

(ARM = adjustable rate mortgage, a mortgage with an interest rate that can change over time.)

Wow. So these homeowners are simply betting that (1) home prices will continue to rise, and/or (2) interest rates won’t rise very much? I’m still learning about real estate, so am I missing something?

“Some may be speculators who want to flip their property when prices improve and want to keep their costs as low as possible in the meantime,” the article adds, which could be a good alternative explanation for what’s going on.

I’m from Sacramento, which has been one of the hottest housing markets in the country for the last few years (here’s some data from 2003). I had lots of opportunities to buy houses with prices that were going up $10,000 per week, where I had to put my name in a raffle just to get the opportunity to buy a house, but I didn’t for a few reasons:

1. I don’t understand real estate (sounds familiar)
2. I don’t understand investing in something when people are getting irrationally excited about it and there’s time pressure, which I pointed out earlier this week usually causes bad decisions. Maybe I’m just not that cool
3. I didn’t want my cash flow going into real estate. Instead, I took it and invested it in myself and my own businesses, which I’m betting can produce a better return than the stock market or real estate. More on that later

Now, with foreclosures and people stagnant growth in real estate, there are blogs like where lots of people are gleeful about the impending doom of the homeowners who made bad decisions. I don’t really care about saying I-told-you-so, but I do want to share what happened when I told people I wasn’t going to invest in real estate.

“What?” people said. “You’d be crazy not to buy now. You can put $0 down!” People also thought I was misguided when I told them that I’d consciously decided not to invest. ‘You must not understand’ was a common sentiment I received, along with a pitying look. And more than one person said, “But real-estate prices don’t go down.” True, over the long term, the real-estate market has done well (not as well as the stock market, though). But the short term can really affect you, especially if your ARM payments jump from $1000 to $1900/month. That’s very likely for lots of people when their ARM comes up–and do you think the average family can afford a doubling of their mortgage?

Yet another point for long-term outlook and not investing in stuff you don’t understand. I think. Unless I’m missing something.

(Btw, I’m far from an expert in real estate and I’m still learning a lot, so last year I brought in Owen Johnson to write a series of real-estate posts last year on iwillteachyoutoberich.)

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  1. I don’t understand people that invest in real estate because they can now get “0% down”. The fact is that in canada, this was always an option its just in the last 10 years or so marketeers decided to drive the point home and obviously people are falling for it.

    Also, If you buy a home and have no money left over to furnish your home whats the point? (Given that you are not using it for “investment” purposes)

    Also, if you buy a home for investment purposes and live in it for 3 years and “make” $30,000 over those three years when you sell, haven’t other houses gone up in price too?

    Investing in real estate is an ongoing big-fish game. You have to be in it for a long time to get a good return on investment because in the short run profits are offset by cost.

  2. I just recently purchased a condon in New York City and opted for a 10 year ARM (10 year interest rate fixed) interest only mortgage over a traditional 30 year mortgage because I knew that I would not be living there for more than 4 or 5 years. I get the rate break and with the interest only feature, I can manage my cash flow a little better. I intend on making payments to principal but at least I have options now. 1 Year ARMS seem very risky to me unless you are absolutely convinced that interest rates will not rise.

    If you wanted to do some research on real estate, google a guy named John T. Reed. I have found most of his advice and materials to be great.

  3. The only reason there is such a massive amount of foreclosures is the same reason people are in debt. They made a really bad decision and tried to live above their means. If you know you can’t afford the actual mortgage, then you shouldn’t do it, but since mortgage brokers offer this interest only loan, people are tempted. It’s really not a good idea if you are looking for a place to live long term. If it is for investment purposes or short term only, then yes, this is the best option. Why spend more money than you have to?

  4. I hate to be cliche, but real estate is all about “getting in the game.” While houses all go up in price, there is some value to be had in the equity that you build up over the years. That equity is what allows you to trade up when you’re ready to move on. Speaking as a resident of South Florida, I am painfully aware that the longer I waited to buy, the harder it would be to ever afford anything at all.

  5. One important thing about real estate purchases is that buying a house to live in is about more than just the investment. You also have the potential to improve your quality of life. I really love living in my house – much more than I’ve enjoyed any apartment I’ve had.

    If you make a financially sound decision about buying you’ll be living in your house for long enough that you won’t be hurt by short-term fluctuations in the housing markets. And you won’t have gotten more house than you can actually afford, so you won’t need to worry about not being able to make your mortgage payments.

    That said, I think the main driver behind much of the behavior you describe is human stupidity.

  6. I can understand the reasoning behind interest only from a cash flow point of view, but I still think it’s a bad idea. Just rent in that case because that’s really all you’re doing, but with much higher risk. You buy a house so you can either live in it for long term or you buy it knowing you’ll build up some equity for the time owning it, but if you’re not building equity, then you’re just renting except with all the risks of owning a house, so there’s no advantage and more risk (although that assumes that the interest payment is comparable or higher than the rent price). I think interest only loans are horrible, and hopefully the economy doesn’t get too hurt from any backlash that will happen.

    Also, on the value of houses, from a macro economic scale houses provide a flat 0% return historically (macro economic scale). Individuals will look around and see gains within their lifetime, but all things considered, the real value of housing is not its return unless you’re in the business of housing. Individuals shouldn’t look to purchasing homes and land for profit if they’re not in it as a business adventure. You should consider the rent costs vs. the mortgage and home owning costs and benefits. Anything on top of that is icing on the cake.

  7. People I’ve talked to seem to think an ARM with a short-term fixed interest period is safe because the mortgage broker thinks the interest rates won’t go up. I hate to break it to them, but the mortgage broker doesn’t know that. No one can say for sure what’ll happen tomorrow.

    I once considered an ARM to get into a very tight housing market. It had a 5 year fixed rate, and my plan was to refinance to a standard loan before the 5 years were up. That sounded sensible until I did more research and realized how much refinancing could cost. I decided to wait until the market calmed down – which is starting to happen now.

  8. “Many who are doing so may have chosen those mortgages not because they want them but because they can’t afford the payments that would come due under a 30-year fixed rate, said Keith Gumbinger, HSH’s vice president.”

    That says it all. If you can’t make the payments on the 30 year fixed option, then you can’t afford to live there. If you can, then you can explore ARMs as an option to save on interest in certain cases, such as the New York condo owner in a comment above. But be careful, because you may plan on living in the house for less than the fixed term of the ARM, but real estate may take a dive and you’d end up having to sell in a down market to avoid the interest rate jump, or you may end up deciding staying put is a good idea. Also, using an ARM and then refinancing to a 30 year fixed once the ARM’s fixed period is up is expensive because of paying the closing costs twice. Also, people have the impression that interest only and ARMs will give them some time to get raises and earn more, so they can “grow” into their future payments (bad assumption because you can’t know what those future payments will be, and what your future income will be). Be careful. If you don’t understand it, or it sounds too good to be true, don’t do it.

  9. Not a real estate bunny here but when buying my personal real estate, I looked for the same two things I look for in an investment, the potential for capital appreciation and positive cash flow (positive cash flow compared to renting over the life of the investment). In an overvalued market, this is more difficult but I believe still doable.

  10. Interesting article.

    I’m “small fry” when it comes to real estate, but at least I’m working on equity. Homes are generally less expensive in my part of the country (upper gulf coast) than in the more populous areas, but we have a great quality of life here.

    I’m glad I refinanced when I did; we bought our home when we got married in 2001; we didn’t know better, and we got a $86k 30 year loan with $5k down and 7.375% interest. But in 2003 when the interest rates bottomed out, I couldn’t ignore the opportunity. I refi’d at 5% for a 15 year loan, paid my closing costs again, and will save tens of thousands of dollars in interest compared to the previous loan (just look at the amortization tables). And I’ll be done 13 years more quickly, AND I’m paying only about $100/month more than with the previous loan.

    Now we’re looking at buying some land; time to research again…