(Nov 2010) Horror stories about adjustable rate mortgages (ARMs), that double and
triple mortgage payments when the rate resets, belie the fact that ARMs can
likewise generate a small windfall of smaller mortgage payments at reset
time.
"Whenever I closed a 5/1, 7/1 etc. I always warned my clients that they
would save money during the fixed rate period, but that they should expect
that it's a bad loan (meaning a high payment) after that," said Stephanie
Noryko, broker/owner of Granite Financial in Cupertino.
"But now, when lending guidelines have tightened up so severely and home
values have declined, adjusting ARMs are, in most cases, declining," she
added.
Fixed rate mortgages (FRMs) come with an interest rate that is fixed for
the life of the loan. For the borrower, that builds in budgeting security --
the mortgage payment remains the same each month.
Not so with ARMs. They come with an interest rate that changes
throughout the life of the loan. How often and by how much the rate changes,
depends on the terms of the ARM, but their lure is an initial rate that is
lower than FRMs.
That gives the borrower the power of financial leverage to initially pay
less a month for the same mortgage than they would pay for a FRM.
For example, in recent weeks, for conforming, 30-year mortgages, the
interest rate on FRMs have averaged about one percentage point higher than
the 5-year Treasury indexed ARM.
That's about $2,000 a month on a $400,000 mortgage for the FRM and $1,770
for the ARM -- a savings of more than $200 a month for the 5-year ARM's
first five years.
But here's the rub.
ARMs come with a starting rate for a given period. The rate remains the
same, typically, from one year to 10. After the initial period, the rate
changes, typically each year. A "5/1" ARM, for example, is fixed for five
years and then resets each year thereafter.
How much the rate changes depends upon the "index," which can rise and
fall; "margins," which, when attached to the index, add up to your current
interest rate; and maximums or "caps" that limit the size of the rate
increase during each period and how high the rate can go during the life of
the loan. "Floors" also limit how low a rate can go.
Because the margin is set with the terms of the loan, the interest rate
is at the mercy of the index.
Common indexes are the 12-month Libor (for London Interbank Offered Rate)
and the 1-Year Treasury.
Average margins run about 2.25 percent to 3 percent, hence the recent 3.4
percent rate on the 5/1.
"I have a client now whose 5/1 will now go down to 3.125 percent and he
had submitted a refinance for a 5/1 at 4.125 percent. He called me recently
after being on vacation and reading lots of business forecasting articles
and decided that he thinks there is a good chance rates will stay low for
the next two to three years so he is going to keep his existing ARM," said
Noryko.
For Noryko's client, the ARM paid off five years ago as a loan that was
cheaper than a FRM, and again, today, resetting for less in the low interest
rate environment.
FRMs remain today's most popular type of loan because there's a demand to
lock in and avoid the potential pain of rising rates that initially came
with the housing market's bust.
ARMs are useful for those who plan well in advance to remain in the home
for a short period of time, say for borrowers who've decided to put off
selling until the housing market rebounds; for those who plan to relocate
soon; or for those approaching retirement and expect to move up, down or
over.
For all those scenarios and others, because ARM mortgage rates typically rise more often then they fall,
ARM borrowers must keep their financial house in order, their debt levels
low and their credit standing high so they are able to refinance or buy anew
down the road.
Holding an ARM comes with a mandate for solid employment, or the cash,
savings or investment to withstand a future rate hike.
All ARM holders should be intimately aware of all loan terms -- the
index, the margin, the cap (especially the maximum over the period of the
loan) and the reset periods.
