The Mortgage Professor

Adjustable-rate mortgage holders vulnerable to sudden rate increase

By Jack Guttentag
Saturday, March 20, 2010

Many mortgage borrowers with adjustable-rate mortgages on which the rate has adjusted in 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, 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 at 2.6 percent. Switching to a fixed-rate mortgage in today's market, even if the borrower commands the best terms, would nearly double the rate. ARM borrowers don't want to double their interest 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 fixed 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 can tempt ARM borrowers to wait until the rate increases start before making a move. But 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 these are unusual times. Indeed, the rise in rates this time could be even faster.

There is no 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. Moving the sale and 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 rate ratcheted up to the maximum over several years should consider refinancing into a fixed-rate loan right away. The savings from the low ARM rate may not justify the risk of getting caught by a rate escalation.

-- Limited capacity to monitor the market: ARM borrowers who don't know how to monitor the market or don't want to should refinance now. Otherwise, they are very likely to be caught by a rate escalation.

Borrowers whose idea of watchfulness is to wait and see what happens to their own rate fall into this category.

The rate on most ARMs adjusts annually after the initial rate period ends, which means that their rate can lag the market by up to 11 months. ARMs that adjust monthly use rate indexes that are lagging indicators, such as the cost of funds index, or COFI.

-- Alert rate-watchers: 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: As soon as the value of the loan's index reaches a certain rate (for example, 2.5 percent), refinance into a fixed-rate mortgage. Alert market monitors should also be alert refinancers. You can't refinance in a day, or even in a week, but you can minimize the time required by developing your refinance strategy beforehand.

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