Strong-Arm

by Peter Schiff

I have read several articles lately pointing out the risks homebuyers assume when purchasing homes using zero-down, interest-only Adjustable Rate Mortgages (ARM’s). Although the writers of these pieces are right to discern risks in these loans, they do not properly identify where the actual exposure lies.

One reason that zero-down payment loans are so popular is that buyers realize that since they put nothing down, they have nothing to lose. When interest rates ultimately rise and home values decline (as they eventually must), the zero-down ARM borrower will be able to walk away from his overpriced home none the worse for wear. The real sufferers will be: lending institutions and private investors left holding the defaulted mortgages, U.S. tax payers who ultimately stand behind the government- sponsored enterprises guaranteeing those mortgages, and home owners with traditional mortgages, who will lose their equity as rising interest rates, contracting mortgage credit, and increased foreclosures result in falling real estate prices.

Given the no-risk scenario for these borrowers, it should be no surprise that more and more renters have become buyers in recent years. To give you a better idea of how the current lending conditions are sucking buyers into the market place at unsustainable rates, below are 10 reasons why buying a house using a zero down, interest-only, five-year ARM, with the intention of defaulting on the loan after the fifth year, is better than renting.

1. When renting, landlords typically require a security deposit and last months rent. When buying with zero down, there is no up-front money needed.

2. With the initial low rate, monthly mortgages payments are often less than what one might otherwise pay in rent.

3. Mortgage payments are tax detectable.

4. During the initial five-year period, monthly mortgage payments are fixed, while rents can increase yearly.

5. The quality of homes for sale is generally better than the quality of those for rent.

6. Homeowners might have access to better public schools than renters.

7. Homeowners can extract equity, which might result from short-term price appreciation using cash-out refinancing.

8. There is no need to waist money on costly maintenance or other repairs, which typically raise the cost of home ownership for traditional buyers who put money down, or actually intend to repay their mortgages.

9. Homeowners are typically considered better credit risks, making it easier to accumulate additional consumer debt.

10. Prior to defaulting and giving the keys back to the bank, owners are free to salvage what they can from their house, and sell off the parts for what ever they can get. For example wood flooring, marble tiles, granite counter tops, appliances, copper plumbing, fixtures, fireplaces, toilets, even the kitchen sink, could be sold on e-bay to the highest bidder.

All things considered, buying with a zero-down, interest-only, five-year ARM, with the intention of defaulting after the fifth year, is hands-down the best way to rent a house.

While it may be true that most zero-down, interest-only ARM buyers do not actually intend to default, it is inevitable that the availability of this option factors into their decision making process. The fact that no down payment is required makes tangible the lack of downside risk. With no risk, why not take a chance to live cheap and possibly make some easy money? Without this protection, buyers would hesitate to pay such ridiculous prices, or commit to future mortgage payments that they may not be able to meet.

As is the case with any mania, most buyers expect to be able to quickly sell for a profit (before the higher payments kick in). However, if it doesn’t work out that way, it’s the bank’s problem, not theirs. Traditionally, down payments and fully amortized fixed-rate loans protected lenders by making this type of risk-free speculation impossible. Today, lenders are gambling that the desire to maintain a good credit rating will be as effective in preventing defaults as the desire not to lose hard-earned cash. It doesn’t take Jimmy the Greek see this as a sucker’s bet.