Sushi Money

     I’ve come full circle on mortgage loans.  I used to be a fan of Adjustable Rate Mortgages, their flexibility and diverse product makeup.  And they can be a useful tool for specific situations.  But I’ve evolved to being a fixed-rate kind of guy. Why?  Because it’s just simpler over time, and probably costs less over the long run.  If you’re shopping for a new mortgage loan, and your choice is an ARM however, I strongly recommend you find an ARM tied to a U.S. Treasury index rather than a LIBOR or other index.  Why?  Because for quite some time now, the LIBOR interest rates have been moving in the opposite direction from Treasuries… meaning LIBOR has headed up while Treasuries have remained stable and begun trending down.  What does this mean to you?  In a nutshell, when (not if) your ARM resets… that is when the ARM initial rate period ends, and the new interest rate takes effect, a LIBOR ARM is going to reset upwards by more than a Treasury index based ARM will.  

     For example, let’s say you have a 5/1 ARM.  That means your intitial interest rate is fixed for the first 5 years, and then can reset once each year thereafter.  Each reset period is usually “capped” at a certain limit, such as a maximum of 2% per annual reset period, or with some loans the first reset is capped at 6% for the first reset period, and then 2% thereafter.  If you have had a 5/1 LIBOR ARM for the past 4-5 years (probably at a very low rate of 3%-4% plus a 2.5% margin) you need to be prepared for the reset that will increase your mortgage interest rate, especially with LIBOR rates currently around 5.2%.  Add the 2.5% margin to the LIBOR index and the new rate is 7.7%!.   For those with ARMS tied to the one-year Constant Maturity Treasury (CMT or TCM) index, their loan reset will result in a lower mortgage payment than the LIBOR reset because the 1-year TCM is about 4.3%.  Add in the 2.5% margin and the new rate is only 6.8%.

     Here’s an example- remember this only shows the Principal and Interest portion of the monthly payment, since every tax, insurance and PMI situation is different.  The mortgage payment includes PITI and PMI, which means Principal (cost of the loan), Interest (rate), Taxes (on your home), Insurance (for your home) and Private Mortgage Insurance (if your down payment/home equity is less than 20%). The following example is for illustration only, and may not consider specifics of various ARM products:

 

     So in the example above, the LIBOR ARM mortgage payment was higher because LIBOR interest rates are higher for the LIBOR index.  We know interest rates change all the time… the 1-year Constant Maturity Treasury index is lower right now, it’s a simple as that (and maybe after next week it will be even lower)?    And in the example above, the ARM payment resets are only for the next 12 months… in another year they will reset once again.  Will they reset higher or lower?  No one really knows… that’s the ARM game, and each year after the initial period the mortgage rate is going to change in one direction or another, and sometimes dramatically.   Here’s a look at the last few weeks comparing the 1-year Treasury index to the LIBOR index.  The rates are not always that different, and often they are very close, although it seems to me that the “London Inter-Bank Offered Rate” (LIBOR) tends to be higher over time.  In 2007 however, they have been drifting further apart for a host of economic reasons, monetary policy, the Dollar versus the Euro, etc.  It pays to know what Index your ARM is based on:

     And there are many different index values used for ARMS such as COFI, CODI, COSI, LIBOR, CMT, etc, etc.  Here’s a chart comparing the COFI, 1-year Treasury and LIBOR rates:

     We don’t know the future, but we can make thoughtful and careful analysis about our income and debt.  If you’re considering an ARM, think about what happens if interest rates go higher over time… the mortgage payment is going higher as well- can your income afford an increase?  How much?  We have also seen recently that it is not always so simple to refinance a loan, especially if housing prices are falling nationwide.  That’s the bind a lot of people are finding themselves in recently.  And yes, ARM loans have a “maximum interest rate cap” typically around 11% or 12%.  But can you imagine making mortgage payments at those rates?  We probably won’t see those rates of course… but they did in the early 1980’s, and I’m not willing to mortgage my future, and my house, to the risk of higher rates over time and increasing mortgage payments.  If a person has really solid documented income or other sources of personal wealth, they can choose to play the ARM game and just refinance when desired.  The bottom line these days is that ARM rates are not much different than 30-year fixed rates.  So why choose an ARM over a fixed rate loan?  Well, if you can get a lower ARM rate, and  can handle the increased mortgage payment if rates go up, and can refinance when desired based on  your income and wealth, and can sell your home if you can’t refinance, and can deal with watching interest rates over time… then maybe an ARM is for you.  

      I have had ARM loans before, and they served the purpose… but did I truly understand what I was getting into at the time?  Not the first time, but yes for the second time.  My favorite was a 5/1 ARM for two and half years, at 4.3%, and I then sold the home and moved. That ARM saved us a lot of money in interest payments over the short term.  But it was a concern for me because I knew interest rates were going up.  If I had not sold the home, I would have needed to refinance the loan, probably to a 30-year fixed rate mortgage.   And that’s where we are now… trying to keep it simple with the knowledge that our monthly mortgage payment will remain the same. It’s just easier to not worry about payments that might change over time, or what interest rates are doing. 

Remember!  Every Adjustable Rate Mortgage can be different, using a different index, rates, margins, adjustment caps and maximum caps.   Closely examine any ARM loan documents to ensure you understand the loan terms.   

For more information about ARMS and other types of home loans, here is a list of references.  I really like Jack Guttentag’s website as The Mortgage Professor.  He provides a plain-language, no-nonsense approach to a host of information about mortgages, real estate, many tools and calculators and an excellent mistakes to avoid section.

Types of Mortgage Loans - The Mortgage Professor

Adjustable Rate Mortgage Calculator - The Mortgage Professor

Adjustable Rate Mortgages - The Federal Reserve

Adjustable Rate Mortgages - Wikipedia

     What did I miss?