How adjustable rate mortgages could make sense again


If you think mortgage rates will continue to fall, is now the time to get an adjustable rate mortgage, an ARM?

This may seem like an odd question in an era of super-low fixed-rate mortgage rates. This is a result ARMs just aren’t popular. According to Ellie Mae, ARMs accounted for just 2.4 percent of all mortgage originations in October, compared to 6.3 percent in June 2019.

No doubt many people are snapping up fixed-rate mortgages when interest rates are low and refinancing can mean big monthly savings. But perhaps ARMs are being overlooked. Perhaps there is something to be said for financing with variable rates.

Falling mortgage rates and ARMs

The big ARM concern is the interest rate shock. ARM prices can go up and down. Nobody wants to find themselves in a situation where a sudden increase in monthly costs makes the loan significantly less or no longer affordable.

ARMs use rate caps to prevent payment shocks. There may be initial, annual and lifetime rate caps. However, keep in mind that the market has generally been friendly to ARM borrowers.

Mortgage rates have been falling for decades. Not every moment and not every week, but the trend has been down, down, since 1981. This year, mortgage rates averaged 16.63 percent, up from 3.94 percent in 2019, according to Freddie Mac.

The average mortgage rate for 2020 will be even lower. Freddie Mac figures show the typical mortgage price for August, September and October was below 2.9 percent. Despite a pandemic, the worst unemployment situation since the Great Depression, massive fires, numerous hurricanes and a belligerent political environment, chances are 2020 will see the lowest mortgage rates since Freddie Mac began collecting data in 1971.

The Mortgage Bankers Association expects mortgage rates to rise in 2021, a forecast that reflects the consensus view. But as low as interest rates are, they can certainly fall further. “While interest rates and mortgage rates are low now, there may be reasons for ARMs and possibly even lower interest rates than we have now,” says Stuart’s Craig Kirsner Estate Planning Wealth Advisor in Coconut Creek, Fla

“When we have the next crash and the next recession,” Kirsner adds, “the government will probably do the same thing again: cut interest rates and stimulate the economy more.”

Starting prices for ARMs

ARMs have traditionally been offered with starting interest rates below fixed rate lending rates. The reason for this is that lenders want borrowers to finance and refinance with adjustable interest rates to offset inflation.

Today, however, the benefit of lower ARM launch rates is gone. For example, on November 19th bank rate reported that fixed rate loans were typically available at 2.96 percent, while 5/1 ARMs were typically available at 3.03 percent. The difference between the two rates is small but important. A $300,000 mortgage at an interest rate of 2.96 percent has a monthly cost of principal and interest of $1,258.35. An ARM with a 3.03 percent launch rate has an initial monthly cost of $1,269.67. That’s a difference of $11.32 per month or $135.84 per year.

Because a 5/1 ARM has a fixed interest rate for the first five years, the additional cost during the ARM’s startup phase is $679.20. Would you pay more for ARM funding? Some borrowers might believe that an ARM will allow them to earn a lower future interest rate without the cost of refinancing. Or some borrowers may prefer an ARM because qualification standards are more liberal, increasing the chance of funding.

ARMs and interest rate risk

The importance of generally falling mortgage rates is that they offset a fundamental ARM risk. When you get fixed rate financing, your monthly cost of principal and interest is fixed for the life of the loan. If you receive an ARM, the rate may change. That means the monthly cost of principal and interest can go up and down.

Rising rates are a powerful ARM problem, especially when rates are rising when borrowers are on less income — think of all the job losses recorded in 2020. However, if interest rates are generally falling – as they have been for almost 40 years – then perhaps the risk of rising interest rates is not so worrying. This seems logical, but as they say on Wall Street, past performance does not guarantee what will happen in the future.

Discussions about interest rate risk and ARMs usually ignore the reality that there is also interest rate risk with fixed rate mortgages. When interest rates are falling and a mortgage rate is set, the borrower may want to refinance to get a lower interest rate. It costs money and you have to be qualified.

Forget interest rates in the 2 percent range. What if interest rates go down? Much deeper. Think of US-unprecedented mortgage rates, submarine rates, rates so low lenders have to reprogram computers. Is it possible that when mortgage rates fall into a huge financial hole, ARM borrowers could end up with a zero or even negative mortgage rate, a rate that forces lenders to pay borrowers? This actually happened in Europe.

The ARM floor for life

ARMs traditionally had no minimum rate. That changed in 2016 when Freddie Mac set a lifetime interest rate level, the lowest interest rate level that an interest rate could attain. Fannie Mae followed suit in 2017. The ARM life floor is now typically equal to the margin on the loan.

ARM interest rates combine an index and a margin. The index moves up and down according to independent measures such as the development of the bank rate, LIBOR (London Interbank Offered Rate) or government bonds. The margin is a fixed number.

Let’s say you’re looking at a 5/1 ARM. With this form of financing, the interest rate is fixed for the first five years of the loan term. After that it can go up or down once a year. The loan could be set up with an initial interest rate of 2.85 percent. It could also have a margin of 2.25 percent. This puts the index at 0.60 percent. (2.25 percent plus 0.60 percent = 2.85 percent)

  • If the index falls to 0.40 percent in five years, the new rate is 2.65 percent.
  • If the index rises to 1 percent, the new rate is 3.25 percent.
  • If the index falls to 0.00 percent, the new rate is 2.25 percent.
  • If the index turns negative going to -0.25 percent, the new rate will still be 2.25 percent below the lifetime ground rule.

bottom line

It’s entirely possible that mortgage rates will fall. ARM interest rates can fall, but the ability of ARM interest rate levels to fall is limited by maturity floors. Borrowers interested in ARMs should look for the lowest possible margin when purchasing an ARM, as well as the best starting rate and lowest caps.

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