RateWatch #337 – Intermediate Term ARMs
January 4, 2002 By Dick Lepre
A smidgen of good economic news on Thursday was all that equity markets needed to start the year buying. This hurt Treasuries and mortgage rates no doubt making many loan officers sorry they took off early on New Year's Eve.
The technicals indicate higher rates. Increased corporate issuance of debt, if it actually happens, will stimulate the economy buy hurt Treasuries and mortgage rates throughout the year. Bonded debt consists mainly of Treasuries, MBS, corporate debt and securitized credit card debt. With the Treasury Department presumed to be doing more borrowing and corporations doing more borrowing, MBS will not be the only game in town.
Intermediate Term ARMs
In quoting rates every day and discussing where they are going we always make assumptions about what folks understand. It would be good to discuss what these loans are for the benefit of folks new to mortgage terms.
The folks who lend money on mortgages are taking certain risks. One risk is that the loan will not
be paid as agreed and that they will have to foreclose. Lenders hedge this by identifying loans that are more likely to result in foreclosure and charging a higher rate. Presumably, the money made by the higher rate offsets the risks. When we say "lender" we are generally talking about the holder of the Mortgage Backed Securities that represent the pool of loans containing your loan. It is really this "investor" that is taking the risk.
Assuming that you are the perfect borrower, the lender would still face 2 risks associated with
rate movement. One is the risk associate with falling rates. This may result in an early payoff
of the loan, the termination of the anticipated cash flow and a real economic loss to the lender.
The most obvious case is that associated with repeated no cost refinancing. If you are one of
those folks who did 2 no cost refinancings last year you may take sadistic pleasure in knowing
that the lender who made the first loan probably lost 1.5% of your loan amount.
The more traditional risk is the risk associated with rising rates. Let's say - for the sake of simplicity - that rates are 7.25% and the cost of funds to the lender is 5.00%. The lender makes you a 30 year fixed rate loan. If it is a no point loan it takes them about a year to recover the actual cost of originating the loan. At that point they are even. They are then exposed to a fluctuation in the cost of funds. If the cost of funds rises to 7.25% the lender has a problem. (In practice, the problem is that the securities are "under water" - they are worth less than what the holder paid for them and depending on the composition of their portfolio the repercussions could be drastic or fatal.)
One practical way for the lender to avoid rate risk is to only do adjustable rate loans. If their cost rises your rate rises. If their cost falls, your rate falls. With rates as low as they have been many borrowers want no part of an adjustable rate mortgage. The short term benefit of the lower rate outweighs the long-term risk.
There are some practical compromises and that's where these products come in. The 5/25 and
the 7/23 are exclusively conforming loans. They are technically balloon loans with predefined
conditional extension options. They are fixed for 5 or 7 years and have a one time option to
reset the rate for the remaining 25 or 23 years. The new rate is the FNMA 60-day buy rate
with a "margin" of approximately 0.75%. Three conditions must be met for you to be able to
exercise the option:
1) the property, if owner-occupied originally cannot be a non-owner occupied at adjustment
2) you must have no late payments in the 12 months prior to the adjustment
3) the new rate must be no more than 5% above the old rate.
If all of the conditions are not met you will have to refinance this loan. Your ability to get the adjustment and lock in the rate is not affected by your other credit or your income at that time.
The 5/25 or 7/23 is ideal if you do not intend to keep the property more than 5 or 7 years.
Intermediate Term ARMs
These are loans fixed for 3, 5, or 7 years which are ARM's (Adjustable Rate Mortgages) with long initial periods. My favorite product for refinancing Jumbo loans has been the 5/1 ARM. Generally speaking, the savings in interest is worth the risk associated with an ARM. At present, the 5/1 is about 1% lower in rate than the 30-year fixed. On a $400,000 loan that is $15,000 difference in payments in five years. The fixed rate loan can seem like an expensive insurance
With all of these, the benefit to the borrower is the lower rate - the downside is the future
The 5/25 and 7/23, unlike 5 years ago, are no longer priced so as to afford no cost loans at
a rate any better than 30 year fixed. The investors see these as much too likely to be prepaid.