“I wonder what you thought of Fed Chairman Greenspan’s statements that mortgage borrowers could save a lot of money if they opted for adjustable-rate mortgages (ARMs) rather than fixed-rate mortgages (FRMs).”

While Greenspan’s remarks were carefully hedged, he certainly seemed intent on conveying the view that more borrowers should select ARMs. He made two arguments, neither of which withstands close scrutiny.

FRM borrowers could have saved a ton of money over the last decade had they chosen ARMs instead. This is certainly true but has no implications at all for what borrowers should do now. Interest rates declined during much of the previous decade, but could rise during the next decade; we just don’t know.

My last mortgage, an FRM, was taken out in 1978. Because mortgage rates roughly doubled over the three years that followed, I saved a ton of money compared to those who took ARMs at the same time. I took the FRM because I was cautious, not because I was smart.

The rate difference between an FRM and an ARM can be properly viewed as an insurance premium that buys protection against future rate increases. Sometimes you need the insurance, sometimes you don’t, but you don’t know until the game is over – just as you don’t know if you are going to need fire insurance on your house. If you don’t have a fire, you don’t think of the premiums you paid as wasted. They bought you peace of mind, which is what the rate premium on an FRM buys you.

Borrowers in the United States have a much stronger (irrational?) preference for the certainty of fixed mortgage payments than borrowers in any other country. It is a fact that FRMs with long terms are a standard mortgage only in the United States. But does this reflect some irrational quirk among U.S. borrowers that ought to be discouraged? I think not.

There are two major reasons why most borrowers in the United States have preferred FRMs. One is that the rate premium that they have to pay for an FRM, as compared to an ARM, is much smaller than it would be anywhere else in the world because it is subsidized. Fannie Mae and Freddie Mac, which can borrow at very low rates because they are government-sponsored enterprises, purchase a large share of all new FRMs. In the United States, FRMs are a bargain. FRMs don’t exist elsewhere largely because the rate premium would be too large for borrowers to swallow.

The second reason borrowers in the United States have preferred FRMs is that ARMs in this country are incredibly complicated; few borrowers understand them, and mandatory disclosures under Truth in Lending don’t help.

Most ARMs abroad allow lenders to adjust the rate at their own discretion. This has obvious drawbacks, but it does have the virtue of simplicity. In contrast, ARMs in the United States use a mechanical indexing procedure for making rate adjustments, which eliminates lender discretion but makes the instrument extremely complicated.

Given their complexities, the acceptability of ARMs could be substantially enhanced by good disclosure rules. Such rules would be limited to critically important information and presented clearly.

The most critical information for most borrowers is: 1) What would happen to the interest rate and the monthly payment if the interest-rate index doesn’t change; and 2) What would happen if the loan rate rises to the maximum permitted by the loan contract? A simple and easy-to-understand table for displaying this information is shown on my Web site.

Instead, Truth in Lending requires lenders to provide ARM borrowers with a checklist of ARM features that is meaningless to most of them. Lenders can use their own formats in providing this information, which varies from lender to lender, and there are no requirements for clarity. Some that I have read are incomprehensible. In addition, borrowers may get a useless example of how their mortgage would have worked had it been written 15 years earlier.

If Greenspan really would like to see ARMs comprising a larger share of total mortgages in the United States, he is well-positioned to do something about it beyond just talk. The Federal Reserve administers Truth in Lending, and while its discretion to change it is limited by Congress, it carries a lot of weight with Congress. This would require a willingness to spend political capital on a consumer protection issue, something that the Fed historically has been reluctant to do.

The writer is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.


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