Yes, But
Who's Locking In?
James Grant, 06.20.05, 12:00 AM ET

People used to pay off their mortgages, then they removed the cash when they retired. Now, though, they take out cash as they go.

News of the probable return of the 30-year Treasury bond puts the U.S. government in an anomalous position. It is, for once, setting an example of responsibility and financial discipline. Naturally, the people can't believe their eyes.

As the Treasury proposes to lock in generationally low long-term borrowing costs, more and more Americans are choosing not to. Instead of the standard 30-year, fixed-rate mortgage, they are taking out ARMs. In the past two years the share of adjustable-rate mortgages in new-purchase originations has leapt to 60% from 20%. Who's right, the people or their government? The words don't come easily, but let me try to say them: The government is right.

It was wrong to discontinue issuance of the long bond in 2001. The Administration had a pretext: The deficits in place and in sight were temporary, and long-term yields were high in relation to short-term yields.

The Administration has reconsidered, but the public is stuck on ARMs--on all varieties, especially the interest-only kind, in which for a period of years the borrower amortizes no principal but pays interest only. Turn on the radio in New York and hear a pitch for Quicken Loans 30-year ARM with a six-month teaser rate of 1.99% and 10 years' grace from principal amortization. Open the Wall Street Journal and ponder North Atlantic Mortgage Corp.'s jumbo interest-only loans with a negative-amortization option (say the word and your loan balance gets bigger).

In February 2004 Alan Greenspan advised the Credit Union National Association: "[R]ecent research within the Federal Reserve suggests that many homeowners might have saved tens of thousands of dollars had they held adjustable-rate mortgages rather than fixed-rate mortgages during the past decade, though this would not have been the case, of course, had interest rates trended sharply upward." Very helpful, Mr. Chairman. In fact, interest rates began trending up--he himself started pushing them up--just four months later.

ARMs weren't invented yesterday, and their popularity ebbs and flows. It flows when long-term interest rates are rising, or when the difference between short-term and long-term rates is widening. This time around, however, long-term rates are falling, and the yield curve is flattening. What commends ARMs to today's consumers is the real estate boom. Borrowing at the short end of the yield curve, they get more house for the money.

Take a $385,000 house, assume a 20% down payment ($77,000) and a 30-year, fixed-rate mortgage at 5.75%. You, the homeowner, would write a check for $1,800 a month. Over five years you'd wind up paying the bank a cumulative $108,000.

Now take the same $385,000 house, the same 20% down payment and the same 30-year maturity. But instead of a fixed-rate loan, assume a 5/1 interest-only ARM. For five years you pay a fixed rate--say 5.1%. That's $1,300 a month. Over the five years your cumulative payment would amount to only $78,000.

So the case is settled? Not quite. Starting in year six, the ARM buyer faces two moments of truth. His interest rate is adjusted, or "reset," and only then does he start to pay down principal. And note that over these first five years the ARM buyer has built up no equity, whereas the fixed-rate, amortizing borrower has amassed $22,000.

While not much, it's a start. The American house used to be a kind of savings account. People paid down their mortgages, then removed the cash. Now they take out cash as they go. Last year the homeowning population extracted $640 billion, primarily via home-equity borrowing and cash-out refinancing, or because buyers tend to take out bigger mortgages than the balances owed by sellers.

There is a kind of person who, while borrowing at a low floating rate and paying only interest expense, will amortize principal at convenient intervals. More than that, this exemplar of judgment and self-discipline will make the hard decision to convert his floating-rate loan to fixed at the moment when interest rates make their long-delayed move to the upside. If you are that person--and I know there must be one--I salute you. For the rest of us the 30-year, fixed-rate loan provides a source of both financial discipline and peace of mind.

Long-term interest rates the world over are at 50-year lows, and, indeed, just might go lower. (Fellow columnist Gary Shilling thinks they will; see page 162.) But the U.S. Treasury, in disclosing the possible return of the long bond, has asked the right question: Why not lock in low rates while we have them?

James Grant is the editor of Grant's Interest Rate Observer. Visit his homepage at www.forbes.com/grant.