Tuesday, June 19, 2007

A Contrarian on Interest Only ARMs

So let's assume you've got full use of your cognitive facilities, and actually get the best loan for which you qualify. But should it be a conventional, ARM, or what? Obviously not an interest-only ARM... as we've already assumed you're not stupid.

But wait... here's a contrarian view. Everyday Finance rightly points out that you don't pay down much principle in the first several years of a loan. And if you're not planning on living in your home more than the time period of the interest-only rate, then you haven't lost much. At 6% interest, in the first 10 years of a 30 year loan, you'd pay down less than 17% of your principle, or about $49,000 on $300,000. So from a risk perspective, it's not as bad as people make it out to be. And if you don't blow that extra money on hookers and coke, you can actually get better returns.

If you've got a low low interest rate (assuming taking interest only doesn't increase your rate), you're probably better off investing your extra cash elsewhere like, say, the stock market. Then instead of $49,000 in equity you could have $55,000 in stock. Hell, I do this with my 1.9% APR car loan right now. Lexus Financial Services is investing in Powershares Water Resources (PHO) on my behalf, and I'd never pay off that loan if I didn't have to.

Don't quite agree with everything in Everyday Finance's analysis (for example, paying down principle is not the same as giving the bank free money) but the key point remains - don't be a sheeple and blindly accept advice from Money Magazine without thinking it through on your own.

SubPrime by Choice

One of the key assumptions of neoclassical economics, one that colors theories and analysis put forth by its practitioners, is that people act in their own rational self interest. How, then, can they explain this report from Fannie Mae that half of the sub-prime loans they purchased in 2005 were held by borrowers that could have qualified for prime loans?

Let's pause for a second to digest that.

The difference between prime and sub-prime loans could be up to 3 percentage points. Even if it's just two points, you're looking at hundreds of dollars a month on your standard Los Angeles mortgage.

So who doesn't shop around when they are taking out a $300,000 loan? Rational people for whom the the several hundred dollars a month is worth less than the time it would take to find a better loan? I'm pretty sure that The V-Train's meddlesome cousin (a former sub-prime loan underwriter) has something to do with this.

Or perhaps people act in their own self interest only if they can recognize what their interests are. Rational, but retarded.