When Are Adjustable Rate Mortgages a Good Buy?

December 3, 2001

"With interest rates at historically low levels, I advise my clients to avoid adjustable rate mortgages (ARMs). Do you agree?"

No. In the current market, some ARMs are unusually attractive for borrowers who can handle the risk.

The market today believes that interest rates are more likely to rise than to fall. We know that from the large spread between short-term and long-term rates. On November 28, 20-year Treasury securities yielded 5.63%, compared to only 1.87% on 3-month securities. Unusually large spreads like this reflect a strong preference for investing "short", preserving the opportunity to reinvest later when rates are expected to be higher.

The market’s view that interest rates have no place to go but up may be correct, but I’m not convinced. After World War II and through the 1950s, mortgage rates were in the 3.5-5% range. While they can’t fall below zero, there is still plenty of room for declines from current levels. Meanwhile, ARMs on which the interest rate is tied to a short-term rate index are attractively priced.

On November 28, a large national lender was charging 6.75% for a 30-year fixed-rate mortgage (FRM), and 6.125% for a 5-year ARM that was otherwise identical. In month 61 and every year thereafter, the rate on this ARM is adjusted to equal the rate on 1-year Treasury securities at that time plus a margin of 2.75%. The 1-year rate on November 28 was 2.26%. The current rate plus margin, called the "fully-indexed rate" (FIR), was 5.01%.

If a borrower knew with certainty that he would be out of the house within 5 years, the FIR could safely be ignored. The problem is that few borrowers are in a position to be sure. Life plays tricks. Most borrowers need to consider what may happen to the rate after 5 years. The FIR is an important indicator of the future ARM rate.

If market interest rates don’t change over the next 5 years, the rate on the ARM in question will drop from 6.125% to the FIR of 5.01%. This is unusual. Usually the FIR is above the initial rate, which results in a rate hike at the first adjustment date unless market rates decline. The relatively low FIR makes the ARM an attractive gamble even for borrowers with long time horizons.

Let’s suppose that the borrower choosing between the FRM and ARM selects the ARM but makes the larger FRM payment. At the end of 5 years, he will owe $3548 less, for each $100,000 of loan, than if he had taken the FRM.

In a stable rate environment, the rate would drop to 5.01% in month 61 and stay there. If the borrower continues to make the FRM payment, the ARM will pay off completely in the 23rd year. At that point, had he selected the FRM instead, the balance would be over $46,000!

That’s the upside of the gamble. The downside is the risk that rates will rise, increasing the ARM payments after 5 years. Borrowers with long time horizons especially need to be comfortable that they can handle this risk.

The best way to assess ARM risk is to assume a "worst case" scenario where market rates explode. In a worst case, the rate adjustment on an ARM depends on its contractual protections: an adjustment cap limits the size of a rate increase, and a lifetime cap sets a maximum rate over the life of the ARM.

The ARM in question has an adjustment cap of 2%, and a lifetime maximum of 10%. This means that the worst that can happen is that the rate will increase to 8.125% in month 61, and to 10% in month 73 where it will remain. If that happens, the payment will rise by 20% in month 61 and by 16% in month 73.

However, the ARM borrower who makes the FRM payment during the first 5 years reduces this risk. Because of the more rapid pay down of the loan balance, the payment increase in month 61 is less than 9% rather than 20%. The payment increase over the two years is 26% rather than 39%.

The reason I selected a 5-year rather than a 7-year ARM is that the adjustment cap on 7-year ARM is 5% rather than 2%. This makes the worst case on a 7-year much worse than on a 5-year. BUT BEWARE! Some 5-year ARMs also have a 5% adjustment cap, and some have maximum rates of 11-12%. For a checklist of all the information you should have in shopping for an ARM, click here.

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