Beware: Your Adjustable-Rate Mortgage May Reset Lower

November 5, 2013 1 Comment »
Beware: Your Adjustable-Rate Mortgage May Reset Lower

One of the greatest fears adjustable-rate mortgage (ARM) holders have is the risk their interest rate may increase.

After all, ARMs come with initial teaser rates that are priced below market to lure in borrowers in the first place, so upon reset, rates are mostly expected to increase.

It’s for this very reason that the vast majority of homeowners opt to go with fixed-rate mortgages instead, choosing to pay an interest rate premium in exchange for the absence of risk.

But what many borrowers probably don’t consider when selecting a mortgage is that an ARM can also adjust downwards as well.

Mortgage Indexes Are Rock Bottom

That’s actually been the case over the past several years now, thanks to mortgage-related indexes like LIBOR that dropped to record lows (below 1%) from around 5% just over five years ago.

When you factor in the margin, which is the other key piece of the adjustable-rate mortgage pie, you’re looking at a lower fully-indexed rate at adjustment, something most homeowners probably never imagined when they took a gamble on an ARM.

If you recall the infamous mortgage rate reset chart that circulated on the net during the onset of the credit crisis, there was a lot of panic that homeowners would see their monthly payments skyrocket upon first reset.

And sure, that may have happened to those with extremely short-term ARMs, like 1-month and 1-year ARMs. But a lot of homeowners back then took out 3/1, 5/1, and 7/1 ARMs, all of which didn’t see their initial adjustment for three, five, and seven years, respectively.

So during the fixed period of their ARM, mortgage indexes kept marching lower, and once that first adjustment came around, homeowners were probably pleasantly surprised.

Heck, the 1-year LIBOR is hovering around 0.60% at the moment. Add a margin of say 2.5% and you’ve got an interest rate close to 3%, which is well below the prevailing rate for a 30-year fixed, and even lower than the 15-year fixed mortgage at the moment.

63% of Hybrid ARMs Have Already Reset

Yesterday, Lender Processing Services released its September Mortgage Monitor report, which highlighted the fact that nearly two-thirds (63%) of outstanding hybrid ARMs had already reset.

And guess what, the sky did not fall. What did fall was the interest rate many of these homeowners were paying.

Another 36% of outstanding ARMs have yet to reset, but LPS noted that the “vast majority” come from newer vintages where credit and loan underwriting quality was “pristine.”

Not that it matters all that much, seeing that most of these borrowers can look forward to a reduction in mortgage payments, as opposed to an increase.

The only hitch is the periodic cap, which limits how much the interest rate can drop initially, and the possibility that there is an “interest rate floor.”

Some ARMs have a floor that limits how much the interest rate can drop throughout the life of the loan, which means some borrowers may have only seen their rates remain steady. Still, the fear of exploding ARMs seems to be dead in the water.

In fact, LPS added that mortgage indexes would need to rise around 3% for most of the pre-crisis hybrid ARMs to actually reset higher.

Those with HELOCs have probably done pretty well too, seeing that the associated prime rate has fallen from over 8% to just 3.25% today.

Now, this isn’t a call to ARMs by any means, it’s just a consideration for those comparing ARMs and FRMs. Look at the margin, the index, the caps, and the floor, if applicable.

Also note that we’re in a very unique interest rate environment at the moment, and most economists expect interest rates to increase fairly significantly over time, meaning future ARMs will probably adjust higher.

So the argument to go with a FRM, despite the interest rate premium today, is still very compelling, unless of course, you’re very rich.

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One Comment

  1. Dominick February 16, 2014 at 11:35 pm -

    Fat chance. Lenders have caught on and now have rate floors that pretty much prevent this from happening.

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