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:
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.