Adjustable Rate Mortgages . . . OOOOhhhhhhh . . . . AAAAhhhhh

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“click, click, click, click, click, click, click . . . click, click, click”

coaster

Adjustable rate mortgages (ARMs) have become increasingly popular over the past few years . . . and not so much in the past six months. With mortgage rates hitting historic lows a few years ago, some adjustable rate mortgages (with rates in the high 3% and low 4%) were just too good for consumers to pass up. Just think (or remember, if you were one of them), if you owed $200,000 on your mortgage at 7%, you could refinance and drop your payment by $500, $600 or even $700 per month. Good idea? or too good to be true?

For a lot of consumers, ARMs were (and in some few cases still are) a good tool to help manage their monthly payment. Because the average homeowner stays in a house for 6 to 7 years (and in Atlanta, I would guess that timeframe to be even lower), the need for a 30 year mortgage is not entirely practical. This of course, flies in the face of our parent’s advice and life-experience . . . “I remember when Jimmy Carter was President, we had a 15% rate on our mortgage and it was an adjustable rate loan!”

The issue lies in how people use the tool. A lot of consumers used interest-only adjustable rate mortgages (specifically the first type of interest-only ARM introduced to the market which was a one-month adjustable rate loan) to purchase more house than they could typically afford. With hopes of upward mobility and/or a steady increase in salary at work, some of those people now find themselves in a pinch to make their payment. This one-month ARM mortgage, and now most adjustable rate mortgages, are based on the LIBOR index which is loosely tied to Prime rate. Prime rate, follows the Federal Funding rate (see previous post), so, basically, as the Feds have raised the Federal funding rate (now 17 times in a row), people with one-month LIBOR arms have watched their rate go up more than 4.0% in the past year and a half. Hopefully, most have not watched the whole time and have at some point refinanced out of that one month LIBOR ARM and into something a little longer-term. If you have not yet refinanced, stop reading and call me . . . seriously, that’s enough . . . stop reading and pick up the phone.

If you leveraged this type of loan as a tool to save cash, and if you “got-in” and “got-out” at the right times (even with the cost of refinancing your mortgage twice — once to “get-in” and once to “get-out”), you probably saved a few thousand dollars. And depending on how long you stay in your house (since the last time you refinance) will determine if you made the best decision . . . or if you would have been better off locking-in for 30 years at 4.875%.

Despite the bad-press that ARM’s are now getting (hey, I’d be angry if my payment went up by $600 over the course of two years), certainly they can’t be that bad, right? In 2004, Fed Chief Alan Greenspan had this to say about adjustable rate mortgages: “”Homeowners might have saved tens of thousands of dollars had they held adjustable-rate mortgages rather than fixed-rate mortgages during the past decade.” Realizing that many consumers have gotten over their heads, and as the state of the economy has changed, I think the past Fed Chief would urge people to use caution when considering an adjustable rate mortgage (and specifically ones with an interest-only option).

index graph

Just as a piece of historical/common sense/mortgage-trivia . . . by looking at the graph above, when do you think that the one-month-interest-only adjustable rate mortgages became most popular (remember, the rate is based on the LIBOR index)? You guessed it . . . 2003.

Since the time of the introduction of the 1 month and 6 month ARMs, investors now offer intermediate adjustable rate mortgages (sometimes called “fixed-term adjustable rate mortgages”) that have a period of time in which the rate is fixed — usually 3, 5, 7 or 10 years. These types of loans give consumers the benefit of an interest-only payment (and a slightly lower rate compared to a 30 year fixed) with the security of a fixed interest rate for a certain time-period — 3 years, 5 years, etc. Unfortunately, with the Feds movement in short-term rates (and the subsequent movement in the LIBOR index) these types of loan rates have become squeezed closer to the fixed rate loan to where the savings, and benefit, of these types of loans have become less and less appealing. Because the monthly payment also increases to a principle and interest payment at the time of the first rate adjustment, consumers should be careful to weigh the benefits of a lower payment with the risk of still being in the house at the time the payment adjusts.

There are certainly some advantages to having an interest-only ARM. The interest-only payment allows flexibility in cash-flow, allowing consumers to put money other places (consumer debt, car payments, retirement savings, education savings, etc).

What would happen if we both purchased identical houses in the same neighborhood and mortgaged $200,000. (The reason I say the “identical house in the same neighborhood” is to take the variable of appreciation out of the argument). You obtained a 30 year fixed-rate mortgage at 6.5% and I got a 10/1 interest-only ARM at 6.375%. My total monthly payment (interest only) would be $202 less than yours, but your payment would include a principle and interest payment. If I invested the $202 per month in a mutual-fund account, who would end up ahead after 5 years? 10 years? What if I took the additional $202 and pre-paid the mortgage? Who would be ahead?

The answer to these questions and my advice to ONLY prepay a loan that re-casts, next time.

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3 Responses to “Adjustable Rate Mortgages . . . OOOOhhhhhhh . . . . AAAAhhhhh”

  1. an MTA loan, (sing) “More than meets the eye.” « The Mortgage Blog Says:

    […] MTA stands for Monthly Treasury Index.  This type of loan (generally named an MTA loan, a Pay-Flex loan or a Pay-Select loan) is a one month adjustable rate mortgage based on the MTA index.  The MTA index is an index calculated based on the twelve month average of annual yields on actively traded US Treasury Securities — the Monthly Treasury Average Index.  Because this index is an average of the previous twelve months, it is a much slower moving index than all other adjustable rate mortgage indices.  For more information on adjustable rate mortgages (ARMs) and how they adjust, check out my previous post. […]

  2. 1rana Says:

    If I have an MTA loan and my lender sends me an option letter and for any reason I missed option letter and did not sign it sent it back and started paying the fully amortized amount. I paid higher amount for a couple of months and now my situation has changed and would like to pay minium payment. Can I do so?

    Please help. Thanks.

  3. hillsidelending Says:

    Unfortunately, loan specifics are tough to give advice on without knowing every detail about your specific MTA loan. I would recommend contacting the loan servicer directly (the company you make your payments to) to find out your options.

    However, if your MTA loan is like most — and the actual rate of interest is close to 7.5% — then I would recommend trying to find a refinance solution that would lower your rate and your payment. If you are in Georgia, give me a call. I’d love to help.

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