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Rising rates

Interest rates have skyrocketed in recent months. The Federal Reserve recently raised its benchmark interest rate to 5.5%, the highest level in 22 years. Consequently, the average 30-year fixed mortgage rate is now roughly 7.6%. That creates difficulty for young, first-time homebuyers and families with modest incomes who may not be able to afford payments, or qualify for mortgages in the first place.

The situation may have driven some potential homebuyers to desperation, away from the consistency of fixed-rate mortgages, where the interest rate can stay the same for the life of the loan, toward much more volatile ARMs, where the rate is tied to an index and can go up or down after a certain number of years.

A recent survey by Rocket Mortgage found that 43.1% of respondents would consider an ARM to get their foot on the property ladder. Among respondents who were currently seeking to purchase their first home, 65.4% said they would consider an ARM.

ARMs generally have initial lower rates than 30-year fixed rate mortgages, which could be one of the reasons why buyers find them appealing. Some buyers might also be speculating lower interest rates in the future, which could be another reason for the popularity of these products.

But Ramsey believes banks employ a sneaky trick to make these ARM terms less favorable to buyers.

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Tricky terms

ARMs can adjust upward quickly when benchmark rates go up but move down slowly when the Fed announces rate cuts.

“Your mortgage is adjusted based on an index [plus] a spread over that index,” Ramsey explained. “But when you start your mortgage, they move you in on a bait-and-switch. The index is already higher than the rate you would have today … Since the index is cheated up, rates would have to go down in order [for your rate to remain the same at the time of renewal].”

Given how slowly rates tend to move up or down, Ramsey says it’s nearly a guarantee your adjustable mortgage will increase upon first renewal.

“Adjustable-rate mortgages are one of the biggest rip offs ever to come along,” he said.

If the Fed continues to raise rates, as has been the case in recent history, adjustable-rate mortgages can easily grow beyond affordability. Homeowners who fall behind on their payments risk defaulting on their mortgage and subsequently foreclosure on the property.

Ramsey’s experience

Ramsey’s opinion on ARMs is based on first-hand experience selling real estate. He describes how banks and financial institutions faced a crisis in the 1980s, when interest rates surged to 17% and loan books were full of fixed-rate mortgages.

Effectively, banks had to pay higher rates to savers but were stuck receiving lower payments from borrowers, who had locked in their rates for 30 years.

Several lenders went bankrupt during this period, which came to be known as the “savings and loans crisis.” In the aftermath of the crisis, Ramsey says, banks decided to protect themselves by creating new mortgages with adjustable rates.

“It transfers the risk from the lender [to the borrower] and ensures that the lender is always going to make money,” he said. “It doesn’t have anything to do … with helping prospective buyers. Bullcrap!”

He continued his rant: “One thing you can count on is banks protecting banks. It’s what they do and they’ve been good at it for a long time. That’s why their furniture is nicer than yours; that’s why their building is bigger than yours. It’s not an accident.”

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About the Author

Vishesh Raisinghani

Vishesh Raisinghani

Freelance Writer

Vishesh Raisinghani is a freelance contributor at MoneyWise. He has been writing about financial markets and economics since 2014 - having covered family offices, private equity, real estate, cryptocurrencies, and tech stocks over that period. His work has appeared in Seeking Alpha, Motley Fool Canada, Motley Fool UK, Mergers & Acquisitions, National Post, Financial Post, and Yahoo Canada.

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