Safe Variable Rate Loans

Variable-rate lending need not be risky

The only safe loan is the one you don’t make.

If you encounter me on the street and ask, “How you doing?” I will invariably answer, “Better than I deserve.” And if you have any familiarity with Dave Ramsey’s radio program, you’ve heard that phrase before. I stole “Better than I deserve” from him decades ago. He can afford it, because his net worth is much, much greater than mine. Besides, there’s no law against stealing, “Better than I deserve.”

I say this to introduce a story about three decades ago. At that time, Dave Ramsey had a finance degree and used it to become a high flying real estate mogul worth millions. And I was a geek with an engineering job who bought a couple rental houses. I had three mortgages and I was following the conventional wisdom to “leverage other people’s money.”

Mr. Ramsey was doing the same, but cranked up to 11 and far more competently than I.

Then the federales changed the tax code and this reduced the tax advantages of a lot of real estate. This nuked the value of the collateral backing many bank loans. I had purchased my rental houses via “land contracts” wherein the lender was the seller, not a bank. They say a land contract is riskier than a conventional mortgage because the lender can foreclose more quickly in the unhappy event of a default.

But risk is a multi-dimensional thing. Whereas I borrowed from individuals, Mr. Ramsey borrowed from financial institutions. The tax change and some S&L hijinks precipitated something called the “credit crunch” which forced these financial institutions to “call” Mr. Ramsey’s loans. This collapsed his financial empire and brought about his bankruptcy. (He has since rebuilt his financial empire even bigger.) My lenders did not have this option so I survived intact.

These were risks the young Mr. Ramsey did not foresee. I was blind to these risks, too, but my lenders didn’t have the same power to screw me over that his lenders had. Risk is, as I said, a multi-dimensional thing.

The point is that all debt is risky, and the risks are sometimes hard to discern.

You may have heard of variable-rate loans. These exist because of a specific sort of risk that lenders wish to offload to the borrowers. Lenders do not want to be locked into unfavorable rates. Thus the variable-rate loan is structured so that the lender gets more money when market rates rise.

Happily, the federales only allow banks to rob you blind after they disclose how they intend to do so. The loan must be documented with appropriate disclosures. Variable-rate loan disclosures must include a worst-case example. It says how high and how fast payments can grow should market rates go nuts. The law requires the lender to disclose the worst-case payment amount.

Tempted to get a variable-rate loan? Don’t do it.

Still tempted? You probably cannot afford it.

Insistent upon borrowing?

Here’s an idea.

Is there a variable-rate loan available at a lower rate than your best fixed-rate deal? How much is its worst-case payment? Will it fit in your budget? If not, you cannot afford the variable-loan. Walk away.

But suppose you can–today–afford the worst-case payment in your current monthly budget. If you are silly enough to take out the variable-rate loan, here is how to minimize your risk due to rate hikes: Pay the worst-case amount this month and every month. You’ll satisfy the terms of the loan plus ypu’ll make advance principal payments. Make sure that the lender understands this up front. And make sure the loan does not penalize advance principal payments before you take out the loan.

This takes away one risk: that the payment may grow larger than you can afford. All the other risks of borrowing are still there. You save a little each month from the difference between the fixed and variable rates. If I were to ever borrow money again, I’d look into this.

But borrowing isn’t a good idea.

Steve Poling

Masters degrees in math and computer science. Poet in several computer languages. I write stories about Sherlock Holmes' brother Mycroft, steampunk, and SF.

Grand Rapids, Michigan