The Upside of ARMs in Down Markets

In the late 1980s, the California housing market was booming. Even though interest rates were around 9 to 10 percent, homebuyers, investors, and speculators pushed prices higher and higher. Then the recession of the early 1990s hit California hard. Mid- to upper-price-range homes fell in value by 15 to 30 percent. Unemployment rates approached 10 percent. By 1993 to 1994, mortgage interest rates dropped to as low as 6.0 percent. Great time to refinance, right?

Yes. But falling property prices, layoffs, and job uncertainty blocked many recent buyers from refinancing at lower rates. Some couldn't qualify for a new loan because of job loss or feared cutbacks. And among those who could qualify for a refinance (refi), most couldn't swing the deal. Their property values wouldn't support a new loan—unless they could bring cash to the closing table.

So, who did gain? Property owners who in the late 1980s had chosen ARMs. Their interest rates slid down. Some were able to convert their

ARMs (see Secret #38) to a 15-year or 30-year fixed-rate loan at the low rates that prevailed. Although no buyers like to consider down markets, they happen, especially in California and other sometimes volatile urban markets like New York City, Miami, Phoenix, Boston, and Washington, D.C. In those situations, ARMs give owners an advantage over fixed-rate loans, yet this advantage is rarely pointed out.

Few real estate agents or loan reps want to frighten buyers with talk of downturns. Nevertheless, view all outcomes that experience reveals to be possible (or in some cases, quite likely).

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