Sunday, January 23, 2011

In Defense of Adjustable Rate Mortgages

"No!!! We are not getting an ARM! If you want to get an ARM, I am done looking at condos with you!"

"Haven't you read about those people in the newspaper? It's worth it for peace of mind!"

"If you want to get an ARM, I'm not giving you any of the blanket!"

Normal people, like my fiancee, tend to say that they don't want X, no matter what. Economists, in contrast, tend to say that they might want X, if the price was Y.

To see if an adjustable rate mortgage would be right for us, we have to estimate a few parameters. For instance, consider a 5-1 adjustable rate mortgage, where the interest rate is fixed for the first five years. If an ARM offers a rate that's 1 percentage point lower than a fixed-rate loan, that's quite a bit of money: for instance, 1% of $300,000 is $3,000--per year.

If there's a 100% chance (or something close to it) that interest rates won't rise during the duration of our loan, then an ARM is a great deal. But it's very hard to make this assumption. More realistically, if there's a 100% chance (or something close to it) that we'll move to another house within the first five years, then an ARM is a great deal. Neither of these conditions is necessarily true, but we should at least consider if they might be.

But one meta parameter trumps everything else: my spouse's happiness is worth more than potentially saving some money by "gambling" on the mortgage.

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