Bad Idea From Greenspan

March 7, 2004

Apparently, in a recent speech Alan Greenspan told US homeowners that they're better off with variable rate mortgages than with fixed rate mortgages. Let me explain why this is horrendous news.

Right now, interest rates are at the lowest they've been in over 40 years. In fact, it's almost a given that no current homebuyer has ever seen a mortgage rate this low in their entire life. Logically, a homebuyer would want to lock in that low rate, rather than take a chance that the rates might marginally decrease. The Fed Funds rate, the interest rate that the government setsfor interbank lending, is currently at 1%. That rate cannot go below zero, so there's really not much room at all on the downside. The only place rates can realistically go is up.

As soon as the economy picks up, mortgage rates will rise since the Fed cannot be expected to maintain such a low-rate environment at the risk of causing inflation. Anyone with a variable rate mortgage will see those dirt-cheap payments skyrocket. However, all those people with the fixed mortgages will still be paying the lowest interest rates since Eisenhower was in office. It makes all kinds of sense to lock in these low rates, since rates are bound to go higher, right? Why would it possibly be better to take a variable rate mortgage now? Greenspan's advice makes no sense.

Or does it? Now, let me preface this by saying that 1 - Greenspan has been plenty wrong in the past, and 2 - this is an awfully risky bet to take. But let's play along, shall we? Alan Greenspan, as chairman of the Federal Reserve, knows more than just about anyone else about the state of the US economy. And he knows before just about anyone else if there is a recovery up the road or if we're heading for more tough times. Assuming that this is true, and that Greenspan is altruistic, what would cause him to suggest a variable rate mortgage?

He knows rates are going to stay low. For a long time. Friday's horrendous job report convinced the bond markets that there is no chance of a rate increase until after the election at the absolute earliest. Since variable rates are currently lower than fixed rate mortgages, a homebuyer would save money so long as the economy is bad and rates stay low.

Either way, this statement is bad news. If you take Greenspan's advice and rates go up, you'll lose a lot of money. On the other hand, if Greenspan is right, you might lose your job, but at least the mortgage payments will be low.