Why the Lowest Mortgage Rate Can Turn Out to Be a Bad Bet

Sure seems that way, at least according to recent reports. A new Urban Institute study points to an increase in household formation among lower-earning minorities who may not have the means to afford much more than a monthly rent check. A survey by Wells Fargo last summer suggested that high debt levels are holding back millennials from becoming homeowners as well.

If true, this doesn’t bode well for residential real estate developers. It’s certainly not good news for existing homeowners with properties to sell, either. What’s more, a shrinking inventory of affordable rental units could drive up rents, and housing sales may also come under pressure as lenders tighten underwriting standards for fear that values may once again decline.

All this is happening despite government policies that are biased in favor of homeownership (consumer-friendly regulations and tax policies in particular). That and, until recently, an upward spiral in valuations have conditioned consumers to view ownership as an ideal worthy of great personal sacrifice.

Achieving that ideal, however, can also expose them to risks that may not be worth taking.

Consider as an example the adjustable-rate mortgage: A cut-rate loan product that’s touted by banks, mortgage brokers and real estate agents as a way for aspirant homeowners who are rolling the dice on higher future salaries and increasing home values to afford their dreams with the help of tantalizingly low monthly payments at the start of the loan.

The story behind the scenes, though, is a bit different.

The term adjustable is marketing-speak for “variable” or “floating,” in that the interest rate can move any which way. The rate is typically tied to LIBOR or a similar index, and resets at specified intervals — from monthly up to several years at a time — depending on the terms of the ARM. This can be beneficial for the borrower if the interest rates drop in the interim, resulting in a lower payment; or can have disastrous results if they increase to the point of unaffordability. So borrowers who require lower monthly payments early on to make their deals work must also accept longer-term uncertainty in exchange; risks that fixed-rate mortgage lenders had traditionally assumed.

Or had they?

There’s really no such thing as a fixed rate per se. Although the Federal Reserve’s policy actions influence the starting point for interest rates, inflationary expectations and other factors take over from there. So to lock in a particular rate at a particular time and for a particular term, a financial institution would need to find another entity (a so-called counterparty) that’s willing to gamble that rates will remain the same or decline during the same period, for which it would be paid a fee. The value of that fee plus, perhaps, a little more, is added to the borrower’s cost in the form of an interest rate markup.

Obviously, no such hedging is necessary for variable loans, which is a big reason why initial rates for ARMs are significantly lower than for fixed-rate mortgages. Issues for consumers, though, include the timing for the first interest-rate reset, the extent to which the base rate may ultimately increase and the effect all that may have on household budgeting.

Still, this product could make sense for homebuyers who expect to relocate before their mortgage reaches the point of that first adjustment. But that’s a crapshoot, particularly for those purchasers who haven’t much financial margin for error.

A more prudent approach would be to make purchase decisions on the basis of fixed-rate mortgage payments and to be disciplined about that: The numbers either work or the prospective buyer should consider a larger down payment, negotiate for a lower selling price or choose another – less expensive — property altogether.

One more thing. If we’ve learned anything from the recent crash, it’s that buying a house is not a guaranteed winning ticket to financial security. A better way to approach the purchase would be to hope that whatever appreciation in value occurs will at the very least offset the rate of inflation.

Anything more than that is a bonus and a good reason not to double down on price or monthly payment amount.

Remember: Budgets are zero-sum equations in that there are only so many dollars to go around. Housing costs, whether in the form of mortgage or rental payments, should not exceed 25% of pretax income. Otherwise, debtors may have no choice but to scale back in other areas to keep up with their financial commitments.

Living like that can get old really fast.

This story is an Op/Ed contribution to Credit.com and does not necessarily represent the views of the company or its affiliates.