Preparing for payment shock

How ARM borrowers can time market to their advantage

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How ARM borrowers can time market to their advantage

Jack Guttentag
Inman News

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 0.35 percent in January. This means that the rate on an ARM with a 2.25 percent margin that uses this index and adjusted in January is now 2.6 percent.

Switching to a fixed-rate mortgage (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 2.6 percent ARM, who was paying 4 percent initially, probably has a maximum rate of about 10 percent and a rate adjustment cap of 2 percent.

That means that if the one-year Treasury rate jumped overnight to 10 percent and stayed there, the ARM rate would adjust to 4.6 percent at the next adjustment, 6.6 percent one year later, 8.6 percent the year after that, and it would top out at 10 percent 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 percent overnight -- the process occurs over a period of time, which creates a temptation 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, for example, the one-year Treasury rate was 5.29 percent. One year later, it hit 7.28 percent; one year after that it was 10.41 percent; and in March 1980 it reached 15.82 percent. 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, as it depends on their individual circumstances:

Early movers: 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.

Shaky capacity to absorb payment increases: 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.

Limited capacity to monitor the market: ARM borrowers who don't know how to monitor the market and who 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: 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 percent), I will refinance into a (fixed-rate mortgage)."

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 percent below the current FRM rate than for one with an ARM rate only 1-1.5 percent 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.

The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.

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