As rates rise, so does the popularity of ARMs
By Holden
Lewis • Bankrate.com
When mortgage rates are rising, it seems counterintuitive
to take out an adjustable-rate mortgage. But that's exactly what almost
one-third of borrowers are doing.
Adjustable-rate mortgages, or ARMs, made up 32.7
percent of loan applications last week, according to the Mortgage
Bankers Association. That was an increase over the previous week.
Borrowers are flocking to ARMs even as the entire mortgage industry
believes that rates will rise this year and next. The rates on today's
ARMs probably will go up when the adjustment period rolls around.
Why, if rates are likely to rise, would anyone want
to get an ARM? There are reasons, some of them good. The key is
that ARMs have lower rates than fixed-rate mortgages. On a one-year
ARM based on the constant maturity Treasury, the rate typically
is at least two percentage points lower than the rate on a 30-year
fixed. Rates are almost as good on hybrid ARMs, which sport initial
rates that last three to 10 years, then adjust annually after that.
For example, a 5/1 hybrid ARM starts out with a rate
that stays the same for five years, then adjusts every year thereafter.
Rates on these loans generally run between 1 and 1.5 percentage
points lower than rates on 30-year fixed mortgages.
These hybrid ARMs have become popular in the last
few years as homeowners have learned to match their loan to the
length of time they think they'll own their homes.
Key: How long will you stay?
"When I consult someone, I frequently ask them how long do
they plan on staying in the home," says Bob Moulton, president
of Americana Mortgage Group in New York. They always say they don't
know, and Moulton presses further. How long did they live in their
previous home? How long did they live in the house before that?
Do they plan to have children? Will any children move out within
a few years? Is there a possibility of a job transfer or a big pay
raise in the next few years?
More often than not, Moulton's clients conclude that
they won't stay in the house for the life of a 30-year, fixed-rate
mortgage. A typical homeowning family stays in the house seven or
eight years before moving on. So a typical family, in the opinion
of Moulton and many other mortgage lenders, should get a hybrid
ARM.
Homeowners with adjustable-rate mortgages often refinance
right back into ARMs, forgoing the opportunity to grab near-record
low rates for fixed-rate loans. Moulton says a client of his got
a 5/1 ARM in February 2003 because she intended to sell the house
within five years. She called Moulton a few weeks ago to say that
her plans had changed, and that she wanted to keep the house a year
or two longer than she originally intended. "So I refinanced
her into a seven-year ARM vs. the four years she had left on her
five-year ARM," he says.
Think rates, not just payment
Many borrowers focus on the lower monthly payment at the beginning
of an ARM's term and don't worry too much about what will happen
if rates rise sharply in the future.
"Generally speaking, in a rising rate environment
you're going to have more people refinancing into an ARM,"
says Garrett Brief, vice president for product development for mortgage
lender IndyMac Bank. "If they're looking to get cash out of
their property and they still want to avail themselves of a low
rate, the product that will allow them to do that is an ARM."
That might sound backward to people who think of
themselves as cautious with their money. If you get a fixed-rate
mortgage while rates are low and rising, you're locking in a low
rate for the life of the loan, whereas someone who gets an ARM risks
rising rates and bigger payments in the future. But there's another
way to think about it. Call it the Bird in the Hand theory: Get
an ARM and save money now when the savings are a sure thing.
The rock-bottom savings come with interest-only ARMs,
in which the borrower pays only the interest and not principal.
Interest-only ARMs are "a great idea for someone starting out,"
says Gary McCann, executive vice president for Astoria Federal Savings.
"Hopefully, at one point in time, their income goes up and
they can start paying toward principal."
But they're not such a good idea for people who lack
the self-discipline or the income to make payments toward principal.
Most borrowers who get hybrid ARMs, whether
or not they're interest-only, plan to either move out of the house
or refinance before the fixed-rate period expires. But if they keep
the loan until the rate adjusts, they get one to four months' notice
of what their new interest rate and payment will be.
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