Homeowners are taking the risky route and I am confused

Ramit Sethi

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. 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
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.


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  1. Prajacta

    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. Bill

    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. Lorena

    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. Elena

    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. marisa

    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. MyNameIsMatt

    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. Bohemian

    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. Anonymous

    “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. Kimber

    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. bishop

    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…

  11. Ross

    I just sold my house in Maryland and bought a house in North Carolina in October of this year. The mortgage rates were just as you described. The only main difference between the 5-year ARM and the 30-year fixed was that you had to put less money down for the ARM. Maybe some people *must* find a home (for whatever reason) but can’t afford to wait to save up for the down payment? Others seem to be betting on interest rates, like you’ve said, and that’s like going to Vegas and betting it all on black. You might win once or twice but eventually you’re gonna get cleaned out.

    P.S. I had owned my house in MD for 2 years (7-year ARM mortgage) and made ~$55k on the sale of the house. However, if I had not moved down to NC, where the cost of living was prohibitively less, I would have just been re-investing this profit in another house of the same quality and size in MD, as all the houses had gone up in value by that much (blame it on the DC commuters slowly-but-surely migrating north).

  12. Angela

    As someone from the UK, its interesting that people are so afraid of ARM.

    Over here, the types of mortgage you can get are fixed interest, tracker and variable. Fixed interest sound like what you describe as an ARM and are fixed over timescales of 2 to 5 years. Tracker rate track the base rate of interest typically for a set period but up to the whole length of the mortgage. Variable rate, where the interest varies depending on the whim of the mortgage company. Additionally, any of these types can be discounted for a fixed period.

    Its just not possible to get an interest rate fixed for the entire length of the mortgage term. However, if you want to refinance, its usually cheap – the mortgage company you are switching to will generally pick up the legal fees, although you might need to pay them a few hundred pounds, its generally cost-effective.

    Back to the main point, real estate prices do indeed go down, just not often. And, real estate is incredibly illiquid. It would take me at least 6 weeks to sell a propertly and get the money out, if not longer.

    For investment purposes, if everyone else is doing it its probably a bad time – I bet the key to making money is to buy at a low price, regardless of the financing. For you to live in, thats a different sort of choice, one to be made between renting and buying. More a lifestyle than an investment choice as far as money is concerned.

  13. Gomek

    When buying my personal real estate, I looked at these two things:

    1) Was the house somewhere that I wanted to live?

    2) Was the house one that I wanted to live in?

    Being able to afford it was also an import (although somewhat binary) decision. How good of an investment is my house? Meh. It’s hard to imagine over the long haul (20 years), any reasonably chosen house will not pan out good.

    And anyway, my retirement strategy does not rest on cashing out my house to buy a boat. It rests on having my mortgage paid off so I don’t have to make payments anymore.


    If you are buying a house to flip it in 2 years, do not follow this advice.

  14. Fashion Industry Ceo

    in the process of looking for my first home now…trying find something I can buy and then rent out

  15. SCapitalist

    Good for you for having the discipline not to get sucked into the hype of the California real estate market. I am from the East Bay, and saw MANY of my friends parents become “investors” by trying to buy a second or third home. This always confused me because I kept reading reports that the area was one of the MOST volitile markets in the country. Needless to say, many of them are now in negative cashflow positions, with a grim outlook.

    Sometimes it is hard to go against the tide, but people who do are often better off.

  16. Stock Mama

    Real estate prices don’t go down?


    These people didn’t see what it was like in Michigan during the Reagan recession as Detroit and surrounding areas were slam-dunked — houses empty, with “Any Serious Offer” spray-painted across the garage doors.

    House prices can and do decline. All you need is a housing glut. Or a rise in interest rates to slow the market. Or a new eight-lane freeway that will run smack through your “ain’t gonna happen here” neighborhood (or a prison, or a cement plant, etc. etc.). Or the giant factories that employ half of your neighbors close their doors and “outsource” to Guatemala. Oopsie.

    Real estate is USUALLY a decent investment, but you have to know about more than just mortgage points and equity. You have to know the area where you’re buying, and any potential risks there may be to housing prices in the future.

  17. Enrique

    The beauty of living in the United States is that you can become a millionaries in almost everything.

    You can become a millionaire by working and investing, selling hot dogs,harmburgers.

    You can also become rich by buying real-estate, cultivating organic foods, and buying stocks.

    Why go into something we don’t understand or don’t have the passion to learn about it?

  18. Ranjan

    Real estate do not create wealth. They are only worth what someone else (perhaps a bigger fool) will pay for them. They do not generate value by themselves. And they could be sometimes cash-negative. You might get rent, but after deducting costs and EMI, the effective yield is marginal. It is more of an emotional value than anything else.

    It can give you good return only when you find a bigger fool for your property!

  19. Josh J

    Your timing is uncanny… I was just talking about this with a buddy last night at the bar.

  20. NLG

    I found this discussion interesting enough to write a lengthy post about it on my blog. I uncovered some interesting information and analysis pointing to the fact that ARMs have outperformed fixed rate mortgages 9 times out of 10 in the last 50-years.

    I also dug up some data on historical interest rates and posted those too.

    Lastly, I suggested a few different ways of getting involved in real estate investing such as finding an REIT in your area, or getting involved with them on public exchanges.


  21. Chris Fox

    I live in the San Fernando Valley in Los Angeles, California. I watched housing prices go from a median of $230,000 to over $500,000 in the span of three years. If you bought a house that you could afford three years ago you are now sitting on nearly $300,000 in equity.

    Yes, houses require maintenance. They require property taxes. They require insurance. The cost of home ownership is relatively steep.

    HOWEVER…it is still an amazing way to make money if you know what you are doing. 100% of the interest paid on your primary residence is a tax write off. That means on an interest only loan EVERY PENNY you pay on your mortgage is a tax write off. Other than kids can you point to another tax shelter like that? Not that I know of.

    Ten years ago the houses that were $230,000 were worth a little over $110,000. In California, especially the valley, houses are always going up. We saw a temporary reduction after the Northridge earthquake but we’ve averaged over 8% appreciation in value over the last 40 years.

    Now some of you are going to point out that stocks have a higher rate of return. But as I’ve said before you can purchase a house effectively on margin which you simply cannot do with any other investment. I can put $30,000 into a $300,000 house and if get 8% appreciation on the total value of the house I get 80% return on the $30,000 I invested.

    Can you point to another investment that will net you 80%?

    Now all of that aside payoption ARMs are very risky. I know as I’m the vice president of a mortgage bank. When we sell a loan like that to someone we make sure to educate them about the risks. If the borrower makes the minimum payment each month they are shooting themselves in the foot, and the loan should only be used by those responsible enough to make the 15yr or 30yr payment. The minimum payment is there in case you lose your job or are in a job that pays commission.

    All ARMs come with some risk, but the longer the fixed term the lower that risk. A 5yr or 10yr interest only loan in California will, historically, be a very wise investment.

    Can you get screwed by an earthquake? Sure. But you can get screwed in any investment. The trick is being educated before making any sort of choice.

    Do I think now is a good time to buy a house? Definitely not. Values will continue to fall for at least a year if not longer. But at least in California that correction is likely be somewhere around 10% which means your $230,000 house is still worth $450,000 a mere 4 yours later. Pretty good return on your money in my opinion.

  22. Kenric

    In response to Ranjan’s comment, “Real estate do not create wealth. They are only worth what someone else (perhaps a bigger fool) will pay for them.”

    This does not make any sense to me, everything in this world is only worth what someone else will pay for it. You can say the same for stocks, businesses, etc… So I guess nothing creates wealth?

  23. dawn18417

    Too many people borrow money with out the help of a lawyer becuase they think they don’t need one I can read they will say,The lenders are using lawyers on there side so why aren’t the borrowers doing the same.As a side note i am not a lawyer.

  24. Colin Smith

    Interest rates in the US are going to continue increasing until the government stops spending.

    It’s a feature of the government continuing to borrow money to finance the war in Iraq, it devalues the currency and increases inflation. In addition, the OPEC countries, China and Japan are diversifying their holdings out of US dollars because of the fall in value. This brings more dollars back to the US and again, pushes up inflation. With increased inflation goes increased interest rates to soak up the money.

    It’s worth noting that the increased inflation in housing prices is a symptom of inflation in the economy. There’s an inevitable bust after the boom when interest rates increase.

  25. Brian Brady

    For what it’s worth. I attempt to answer your question here:

  26. lonne dortch II

    wow am new to this bog site. and i am loving it.. it’s teaching me alot. thanks.

  27. SV Nagappa

    Real estate creates emotional stability that allows one to create wealth. The reason why many foreclosures happened is because people who could only afford a home worth 150000 went and purchased homes worth 250000 to keep up with the jones not understanding that interest rates go up and they need to keep a bit of give in their ability to pay the mortgage. Living in rented apartment does not give the same security as living in own home. However people need to learn to save as much as people can rather than take 0 deposit mortgages. Americans are very greedy and this greed unfortunately caused misery.

  28. Michael Merritt

    Good post, learning from here.. Thank you for sharing