ARM is making comeback -- and could save arm and a leg

Friday, January 28, 2011; 11:05 AM

After years of virtual exile from the home-loan arena, is the adjustable-rate mortgage staging a quiet comeback? Could an ARM be on your shopping list the next time you need to buy or refinance a house?

You might be surprised by what they offer.

A new survey of 112 lenders by mortgage giant Freddie Mac found that ARMs are starting to attract applicants again. Adjustables accounted for just 3 percent of new home loans in early 2009, but are projected to be the final choice for nearly one in 10 borrowers this year. In the jumbo and super-jumbo segments, the share will be even larger, said Freddie Mac chief economist Frank Nothaft.

How could this be, with fixed 30-year rates at half-century lows, hovering just under 5 percent? Isn't it axiomatic that it's always smarter to lock in a low fixed rate for as long as possible rather than to gamble on a loan whose rate might bounce around?

That logic still holds up for most people, but not for everybody. Here's why. The boom-era models of the ARM have pretty much disappeared - there are no more of the two-year adjustables that hooked record numbers of consumers in 2003 and 2004 with teaser rates that needed to be refinanced with heavy fees within 24 months. No more "pick-a-pay" ARMs that were mass-marketed with loosey-goosey underwriting and negative amortization.

The most popular ARM in the market today, according to the Freddie Mac survey, is the "5-1" hybrid. Its rate is fixed for the first five years, then adjusts annually for as long as 25 years, with protective rate limits to cushion payment shocks if rates suddenly spike. There are also "7-1" and "3-1" hybrids. The antique one-year ARM still is available but doesn't get a lot of takers.

The real key to the growing popularity of hybrid ARMs is in their pricing. Rates are significantly lower than on fixed 30-year alternatives, with no teasers or negative amortization involved. In some cases, they also come with other attractive terms, such as more flexible underwriting standards.

According to data supplied by Dan Green, a loan officer with Waterstone Mortgage in Cincinnati who writes the Mortgage Reports blog, the rate spread between 5-1 hybrid ARMs and 30-year fixed-rate loans has now widened to about 1.625 percentage points.

To illustrate, say you're interested in a $250,000 conventional loan to buy a house. You've got a 740 FICO credit score and want to close in 45 days. You could opt for a 30-year fixed loan at 4.75 percent, requiring a monthly principal and interest payment of $1,304. Alternatively, you could opt for a 5-1 ARM fixed at 3.125 percent, costing $1,071 in principal and interest per month - a savings of $233.

But now check out the niche where hybrid ARMs really shine: jumbo and super-jumbo mortgages. In the D.C. area, jumbos start at $729,750, the current limit for conventional mortgages eligible for purchase by Fannie Mae and Freddie Mac. Super jumbos generally range above $1 million. In lower-cost markets elsewhere in the country, jumbos usually mean amounts above $417,000.

Say you need a $450,000 mortgage with a 45-day closing and you have a 740 FICO. According to Green, you should be able to get a 30-year fixed rate jumbo for about 5.625 percent. Monthly principal and interest on a fixed-rate jumbo would total $2,590 a month. Compare that with a $450,000 hybrid 5-1 ARM: 3.5 percent for the initial five years, requiring $2,020 a month in principal and interest. That's a rate spread of 2.125 points - "the best we've seen in years," Green said in an interview. "It's very aggressively priced" by banks that want to originate them to hold in their own portfolios.

The savings go even higher in the super-jumbo space - a $1 million 5-1 ARM goes for 3.5 percent and saves a borrower $1,266 a month compared with a competing $1 million fixed-rate 30-year loan at 5.6 percent.

Cathy Warshawsky, president and senior loan officer of Bay Area Loan in San Jose, cites another advantage for some jumbo borrowers - special enhancements in payment terms. For example, a client of hers needed a $950,000 mortgage at the lowest rate and monthly payment. She signed him up for a 5-1 hybrid at 5.75 percent, interest-only.

None of this is to suggest, of course, that hybrid adjustables make financial sense for everybody. But if you fit one of the niches - you need a jumbo, you know you're likely to be transferred or you expect to sell the house within the coming five to seven years - they merit a serious look.

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