High Anxiety About Refinancing Low-Rate ARMs

March 1, 2010, Revised October 24, 2010

Many mortgage borrowers with adjustable rate mortgages (ARMs) on which the rate has adjusted within recent years are currently enjoying extremely low interest rates. This reflects the unusually low levels of the rate indexes used by most ARMs. But these low rates are accompanied by high anxiety, because of widespread expectations that rates will rise.

For example, the Treasury one-year constant maturity series, which is a widely used index, averaged .35% in January. This means that the rate on an ARM with a 2.25% margin that uses this index and adjusted in January, is now 2.60%. Switching to an FRM in today’s market, even if the borrower commands the best terms, will about double the rate. ARM borrowers don’t want to double their rate before they have to, but neither do they want to be caught flat-footed by a rate increase that materializes before they can make a move.

The stakes are high. The borrower with the 2.60% ARM who was paying 4% initially probably has a maximum rate of about 10% and a rate adjustment cap of 2%. That means that if the one-year Treasury rate jumped overnight to 10% and stayed there, the ARM rate would adjust to 4.60% at the next adjustment, 6.60% one year later, 8.60% the year after that, and it would top out at 10% one year later. Since the FRM rate would escalate with the Treasury rate, the opportunity for a profitable refinance would be lost.

Of course, rates never jump 10% overnight, the process occurs over a period of time, which creates an opportunity for ARM borrowers to wait until the rate-increase process starts before making a move. That is easier said than done because the market can move very fast. In January 1977, the one-year Treasury rate was 5.29%. One year later, it hit 7.28%, one year after that it was 10.41%, and in March 1980 it reached 15.82%. That was an unusual episode, but we are now living in unusual times. Indeed, the rise in rates this time could be even faster.

There is no one best way for ARM borrowers to deal with this problem; it depends on their individual circumstances. In an article on this topic I wrote in 2005, I laid out the nuts and bolts of a calculator-based analysis that is a bit challenging for some readers. (See Is Now the Time to Refinance an ARM Into a FRM?) The approach taken here should be easier to follow.

Early Movers Gain Little From Refinancing

ARM borrowers who intend to sell their house within, say, the next 18 months, have little to gain by refinancing, because portable mortgages that can be transferred to the next house are no longer available. Such borrowers have a lot to lose if rates escalate before they buy their next house, but refinancing their current mortgage will not help with that problem. Moving the sale/purchase dates up could be a prudent move.  

Borrowers Without Capacity to Pay More Should Refinance Now

ARM borrowers who anticipate that they could not afford the payment if their ARM rate ratcheted up to the maximum over several years, should consider refinancing into an FRM right away. The savings from the low ARM rate may not justify the risk of getting caught by a rate escalation that results in the loss of their home. 

Borrowers Unable to Monitor the Market Should Refinance Now

ARM borrowers who don’t know how to monitor the market, and don’t want to invest the time required to learn how and then to do it, should refinance now. Otherwise, they are very likely to be caught by a rate escalation.

Borrowers whose idea of watchful-waiting is to see what happens to their own ARM rate, fall into this category. The rate on most ARMs adjusts annually after the initial rate period ends, which means that the ARM rate can lag the market by up to 11 months. ARMs that adjust the rate monthly use rate indexes that are themselves lagged indicators, such as the cost of funds index (COFI).  

 Alert Rate Monitors Can Wait and See

These ARM borrowers are prepared to monitor the market and can take the risk of being caught. To minimize that risk, I advise adopting an operational rule, such as this one: “As soon as the [monthly value] of the [Treasury one-year rate series] reaches [2.5%], I will refinance into an FRM.” The first bracketed term might be weekly, the second might be a different rate series, and the third might be a different target rate. I would expect the target rate to be higher for a borrower with an ARM rate 2-3% below the current FRM rate than for one with an ARM rate only 1-1.5% lower.

The rate series used should be one of the open market series that are available daily and weekly as well as monthly. These include the Treasury and Libor rate series, which are used as indexes on many ARMs that adjust annually. Avoid COFI, CODI, COSI and MTA, all of which lag the market. You can find the open market series at www.mortgage-x.com and  www.federalreserve.gov/releases/H15/update/.

Alert market monitors should also be alert refinancers. You can’t refinance in a day, or even a week, but you can minimize the time required by developing your refinance strategy beforehand. This means selecting one or several loan providers who you will contact as soon as you have decided to refinance.

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