My eyes peered across many an economic article in the last few years. No shortage of opinion existed stating the primary economic driver preventing the United States from a long lasting recession, if not depression, is the ability of home owners to extract capital from their homes, and then spend it on consumables.

I am not going to go into a discussion as to whether or not this opinion has merit. What I would like to discuss is how such a transaction (the re-finance mortgage, and in particular the Adjustable Rate Re-fi) is pitched to the home owner. Just for the readers information, my expertise in this area is based upon the closing of over 750 of these transactions in the last 4 years, most of which involved Adjustable Rate Mortgages (ARMs).

An ARM amortizes the principal and a fixed interest rate only for a period of years, normally two to five. After the initial term, the interest rate fluctuates with the prevailing rate at the time. The selling point of this loan type is a lower interest rate than a traditional 30 year fixed rate mortgage. In some instances, the payment can be several hundred dollars a month cheaper. Of course, the borrower is concerned the rates are trending higher and wonders if this is a good idea. The mortgage broker solves this issue as he explains to his client, in six months, your credit will be better, and we can lock in a lower fixed rate at that time.

I witnessed countless instances where this pitch worked with sub prime borrowers. I decided that for this article, I would break it down to dollars and cents since I believe numbers dont lie.

So I ran the numbers using the current rates as found on bankrate.com. I am not entirely sure that you can get a 6.15% APR for a 30 year fixed mortgage, but since this is simply an illustration, lets just pretend, OK?

Now the first 24 months (2 years) of a 30 year fixed amortizes (monthly) as follows:

$ 200,000 @ 6.15%

Payment Interest Principal Balance

9/ 2/2006 1,218.46 1,025.00 193.46 199,806.54

10/ 2/2006 1,218.46 1,024.01 194.45 199,612.10

11/ 2/2006 1,218.46 1,023.01 195.44 199,416.65

12/ 2/2006 1,218.46 1,022.01 196.45 199,220.21

1/ 2/2007 1,218.46 1,021.00 197.45 199,022.75

2/ 2/2007 1,218.46 1,019.99 198.46 198,824.29

3/ 2/2007 1,218.46 1,018.97 199.48 198,624.81

4/ 2/2007 1,218.46 1,017.95 200.50 198,424.30

5/ 2/2007 1,218.46 1,016.92 201.53 198,222.77

6/ 2/2007 1,218.46 1,015.89 202.56 198,020.21

7/ 2/2007 1,218.46 1,014.85 203.60 197,816.60

8/ 2/2007 1,218.46 1,013.81 204.65 197,611.96

9/ 2/2007 1,218.46 1,012.76 205.70 197,406.26

10/ 2/2007 1,218.46 1,011.71 206.75 197,199.51

11/ 2/2007 1,218.46 1,010.65 207.81 196,991.70

12/ 2/2007 1,218.46 1,009.58 208.87 196,782.83

1/ 2/2008 1,218.46 1,008.51 209.94 196,572.89

2/ 2/2008 1,218.46 1,007.44 211.02 196,361.87

3/ 2/2008 1,218.46 1,006.35 212.10 196,149.76

4/ 2/2008 1,218.46 1,005.27 213.19 195,936.57

5/ 2/2008 1,218.46 1,004.17 214.28 195,722.29

6/ 2/2008 1,218.46 1,003.08 215.38 195,506.91

7/ 2/2008 1,218.46 1,001.97 216.48 195,290.43

8/ 2/2008 1,218.46 1,000.86 217.59 195,072.84

And a 5 year ARM amortizes over the first 24 months as:

$ 200,000 @ 5.82%

Payment Interest Principal Balance

9/2/2006 1,176.05 970.00 206.05 199,793.95

10/2/2006 1,176.05 969.00 207.05 199,586.89

11/2/2006 1,176.05 968.00 208.06 199,378.83

12/2/2006 1,176.05 966.99 209.07 199,169.77

1/2/2007 1,176.05 965.97 210.08 198,959.69

2/2/2007 1,176.05 964.95 211.10 198,748.58

3/2/2007 1,176.05 963.93 212.12 198,536.46

4/2/2007 1,176.05 962.90 213.15 198,323.31

5/2/2007 1,176.05 961.87 214.19 198,109.12

6/2/2007 1,176.05 960.83 215.23 197,893.90

7/2/2007 1,176.05 959.79 216.27 197,677.63

8/2/2007 1,176.05 958.74 217.32 197,460.31

9/2/2007 1,176.05 957.68 218.37 197,241.94

10/2/2007 1,176.05 956.62 219.43 197,022.51

11/2/2007 1,176.05 955.56 220.50 196,802.01

12/2/2007 1,176.05 954.49 221.56 196,580.45

1/2/2008 1,176.05 953.42 222.64 196,357.81

2/2/2008 1,176.05 952.34 223.72 196,134.09

3/2/2008 1,176.05 951.25 224.80 195,909.28

4/2/2008 1,176.05 950.16 225.89 195,683.39

5/2/2008 1,176.05 949.06 226.99 195,456.40

6/2/2008 1,176.05 947.96 228.09 195,228.31

7/2/2008 1,176.05 946.86 229.20 194,999.11

8/2/2008 1,176.05 945.75 230.31 194,768.80

There you have it two amortizations for 24 months. Remember, the sales pitch states that the borrower will repair his credit in two years (sometimes as soon as 6 months) at which time he can lock in a lower fixed rate for 30 years.

It seems the borrower saves the difference in the monthly payment ($1,218.46 - $1,176.05 = $42.41) multiplied by 2 years or 24 months (24 * $42.41 = $1,017.84). Keep in mind that the rate difference is 33 basis points or 1/3 of a percent. In some transactions, such as with sub prime borrowers, the difference can be up to 3/4 of a percent. For purposes of our illustration, the borrower obtains a lower monthly payment by about $43 which equates to a savings of just over one thousand dollars over two years. The question then comes to mind, is it worth it? To find out, let us take the analysis a little further.

Forecasting the Rate

Forecasting future interest rates is rather difficult. I do not think I will get much disagreement with that statement. Considering the current trend and historical averages, however, perhaps we can forecast slightly higher rates in the next two years. If this is the case, how can the borrower be sure his payment will go down once his credit score improves? Sure, his score might qualify him for a lower rate, but how much lower, the borrower is unsure. Could it be the rate for a 30 year fixed mortgage is higher in two years than the adjustable rate is on the date of closing? It is certainly possible, is it not? In my opinion, the borrower cannot possibly be sure if his future fixed rate will be lower in the future. The strategy, on its face, fails because it rests on predicting variables interest rates and credit score that are virtually unpredictable in the future.

Conveniently Omitted Closing Costs

But if we delve even deeper, we can more clearly see the folly of this strategy. Below are typical closing costs associated with a residential re-finance loan. This list is by no means exhaustive but is offered only to give the reader an idea about how much a loan could cost an unsuspecting borrower on a $200,000 mortgage loan.

* Application Fee $450

* Loan Origination Fee 2% or $6,000

* Tax Service Fee $70

* Flood Certification Fee $10

* Closing Fee $475

* Title Policy $1,100

* Recording Fees $350

* Overnight and Email $90

* Appraisal $300

$8,845

If the borrower actually re-finances his ARM in two years, he will have to pay these same closing costs over again. Virtually none of these can be avoided unless you have a friend who is a lender. The costs outweigh the dollar on dollar monthly payment savings by over 8 to 1. What a deal! Remember, this calculation does not even consider the time value of money or opportunity cost on interest paid.

Meanwhile, if you look again at the amortizations, you will see that virtually none of the principal is paid after two years. (For more on this situation, read my article entitled, An Interesting Look, written several weeks ago.) What this means is the borrower must start the process again, paying almost all interest for the first several years and virtually none of the principal. In effect, the borrower has been renting his house for two years the bank as the landlord. After all, it is the American way.

Of course, a mortgage banker would probably resent this analysis and likely offer the following rebuttal: An honest banker (trying not to laugh) would make sure the product/loan fits the borrowers needs. For example, a good loan officer would ask whether the borrower plans on staying in the home or if the borrower expects to move in a few years. If he stays put for 30 years, the savings and peace of mind more than outweigh the closing costs.

But this is an awfully big if. And since the borrower misplaced his crystal ball, he usually nods and says he has nowhere to go. But the honest banker knows the vast majority of people move within 5 years and virtually no one pays their mortgage off in full anymore.

The real problem is that people trust these bankers to get them a good rate which the borrower thinks is the heart of the issue. The real issue is the amount of the loan. The rate is simply the smoke screen bankers use to separate their customers from their money, time and time again. I see closing costs in excess of $10,000 in these deals over and over again. But the borrower almost never asks about them. All he is concerned with is the rate and payment. If the figure fits into his budget, he signs the papers. It is as simple as that. A simple look at what it costs clears away the fog yet very few every bother to do so.

I guess they figure the price of real estate will always go up and that the costs are simply what you must pay to play in the real estate market. Essentially, a home owner takes a position in a free market asset just like a trader takes a position in the futures or equity markets. But real estate is usually a highly leveraged asset in an illiquid market. These two characteristics of the residential real estate market pose significant risks to owners of this asset class.

Of course, maybe they are right. Perhaps this time it IS different.

Thanks for listening.