Betting on the ARM
Adjustable mortgages make sense for many -- even now
by Andrea Coombes, CBS Marketwatch

March 10, 2004

SAN FRANCISCO (CBS.MW) -- Most homebuyers want nothing more than to lock in interest rates that, at about 5 1/2 percent for the 30-year fixed, are still hovering near 45-year lows.

But Americans' penchant for moving every seven years on average means some could save a bundle by opting for cheaper adjustable-rate loans rather than paying for fixed-rate mortgages, experts said. "They refinance, they move, they downsize, they upsize," said Ron Chicaferro, president of Thornburg Mortgage Home Loans, based in Santa Fe, N.M. "There are a lot of different reasons to change a loan. Very few people keep a loan for exactly 30 years. "For those who fit that frenetic picture, experts say hybrid ARMs still make sense, even in the current low-rate environment. Hybrids have fixed rates for a set period, after which the rate adjusts, usually annually. A hybrid ARM "essentially functions as a fixed-rate loan as long as you pick the product that corresponds with your intended (time) horizon" in the house, said Greg McBride, senior financial analyst with Bankrate.com. "People are opting for the 30-year fixed or one of the more traditional fixed-rate mortgages when they might be suited for another product because they are likely to change homes at some point," he said. That yen for fixed-rate loans appears to pain Federal Reserve Chairman Alan Greenspan. "Many homeowners might have saved tens of thousands of dollars had they held adjustable-rate mortgages rather than fixed-rate mortgages during the past decade," he said in a recent speech to the Credit Union National Association. ARMs are gaining in popularity, but they represent only about 27 percent of new mortgage applications this year, according to the Mortgage Bankers Association. How high will rates go? Still, as Greenspan noted, Americans wouldn't have saved thousands had rates gone up -- and that's exactly what most worries borrowers. Memories of double-digit interest rates in the 1980s hold many Americans in thrall, and eager to lock in low rates. "Hindsight's 20/20," said Bob Moulton, president of Americana Mortgage Group Inc., based in Manhasset, N.Y. "If everyone knew the rates would trend down, they would have taken adjustable rates." The question is: How high will rates be in a few years, when the adjustable rate kicks in? Over the next couple of years, higher interest rates are "a very real certainty," said Keith Gumbinger, vice president of HSH Associates, surveyors and publishers of mortgage and other financial information. That means choosing a short-term hybrid ARM now comes with some risk. However, given economic cycles, it's possible that purchasing, say, a 7/1 arm now means you "totally sidestep a rising interest rate environment, and when the fixed period for your product ends you might find market conditions very advantageous," he said. "But of course, we don't know yet ... There are some risks in selecting a product whose rate will change down the road." While short-term interest rates might shoot higher than long-term rates, the more likely scenario is "that ARM rates are going to be lower than fixed rates," Chicaferro said. "If I knew rates were rising and would never fall again, then take a fixed-rate today. (But) that's never happened." Remember that while ARMs usually have an annual rate-hike cap of about 2 percentage points, some hybrid products have no cap for the first adjustment. Thus, the rate for a loan with a 6 percentage-point cap overall could rise 5 percentage points at the first adjustment. Plus, be wary of prepayment penalties, which make refinancing before the loan term is over a pricey endeavor. Significant cost savings Some say risk-takers are usually well rewarded. "Any time you don't spend expensive premiums for a fixed rate, you can either invest that money elsewhere or you can accelerate your principal reduction with those funds, so you actually come out ahead," said Stephen Luigi Piazza, senior vice president at Quicken Loans. "There's not a mathematical benefit (to fixed-rate mortgages) that we can show a client over the last 15 years," Piazza said. Borrowing $200,000 through a 5-year ARM at 4.5 percent would mean monthly payments of $1,013, leading to savings of $135 a month over a 30-year fixed rate loan at 5.6 percent, according to Bankrate. Over five years, the savings total $8,100. But at the five-year point, if the ARM rate jumps to, say, 6.5 percent, the monthly payment becomes $1,231, or $83 more than the fixed-rate payment. Still, at that rate it would take more than 8 years of the higher payment to eat up the initial savings. Even long-term hybrids with rates almost as high as fixed-rate loans offer savings. On a $165,000 loan, a 7-year ARM at 6 percent will save a borrower $4,500 in monthly payments over 7 years compared with a 30-year fixed-rate loan at 6.5 percent, according to Bankrate. Even if the ARM rate jumped to 11 percent it would take a year of higher payments to erase the initial savings, McBride said. Not for everyone Even with the cost savings, however, ARMs are not for everyone. If "the borrower is elderly and on a fixed income, a 30-year fixed is probably the best deal, even though they're going to be paying a higher rate. They're in an economic situation where they can't afford any interest-rate risk," Chicaferro said. But some say "elderly" doesn't necessarily imply "fixed rate." "We're even finding elderly people are downsizing or moving to warmer climates," said David Herpers, director of consumer affairs at Amerisave Mortgage. A borrower in a secure job and unlikely to be transferred, or a young family that intends to stay put for 20 years, are good candidates for fixed-rate mortgages. And some borrowers are simply unable to stomach ARM risk. "You have to say, 'If your payment went up $200 would you be OK?'" Piazza said. "Some clients aren't and they're not comfortable thinking that may happen." Greenspan said in his speech that lenders should offer borrowers a more diverse array of products, but some say the products are there -- Americans just aren't asking for them." Consumers call in and many times the first thing is 'what's your 30-year-fixed rate today?'" Herpers said. "That same customer is self-maintaining their IRA and investing in volatile stocks or volatile mutual funds," but they're unwilling to consider a riskier, yet cheaper, mortgage product. Interest-only for the disciplined, only Borrowers should also consider the interest-only ARM, but compulsive shoppers and free spenders need not apply. With an interest-only loan, the borrower pays only the interest at first, and then the loan amortizes for the remaining loan term. That gives you a much lower monthly payment at first, but steep payments later. As with any ARM, using your savings to pay off principal will reduce your hit later, as lenders assess interest on the remaining balance. But people who can't afford a fixed-rate loan shouldn't necessarily reach for an interest-only loan instead, Herpers said, as the payments down the road will likely be too high. Instead, those eligible for the 30-year loan should consider taking the interest-only loan and using the savings to pay down principal or invest. He compared a fixed-rate 30-year mortgage for $200,000 at 5.5 percent, with a 1-year interest-only ARM with a rate starting at 3 percent and rising to 5.67 percent after 10 years. After 10 years with the interest-only ARM, a homeowner who put the savings toward principal would have paid down $10,800 more than with the fixed-rate mortgage, Herpers said. In another example, a homeowner who devotes half his savings to principal and half to investments returning 8 percent on average would, after 10 years, face a loan balance $12,000 higher than with the fixed-rate mortgage, but would also have $37,850 in the investment account. "You're going to see your monthly payment drop in half or perhaps more than half, but it takes discipline to put that toward your principal balance and the investment account and not spend it on consumer goods," Herpers said. "If you don't have that discipline, I wouldn't recommend that strategy." His basis for the ARM rate rise to 5.67 percent after 10 years? "That's a 270 basis point swing. I personally think that's reasonable," Herpers said. "Swings of anywhere from 200 to 300 basis points over the next 5 to 7 years would be plausible," he said. "I'm optimistic that we're not going to see rates such as we did in the Carter administration." Andrea Coombes is a reporter for CBS.MarketWatch.com in San Francisco.