by Broderick Perkins
(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 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 fixed rate mortgages.
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 fixed rate mortgage.
For example, in recent weeks, for conforming, 30-year mortgages, the interest rate on fixed rate mortgages have averaged about one percentage point higher than the 5-year Treasury indexed ARM.
Fixed rate mortgages for conforming loans averaged 4.39 percent vs. 3.40 percent for the 5-year Treasury indexed ARM, according to Freddie Mac's Nov. 18 Primary Mortgage Market Survey.
That's about $2,000 a month on a $400,000 mortgage for the fixed rate mortgage 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 fixed rate mortgage, and again, today, resetting for less in the low interest rate environment.
Fixed rate mortgages 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.
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