The Mortgage Reports Blog

Wait! Before You Ditch That ARM, Make Sure Your Mortgage Rate Won't Be Adjusting Lower

Homeowners with ARMs often assume that they have to remortgage when their home loan reaches the end of its fixed-rate period.  They automatically think their mortgage will adjust higher and that a new mortgage could provide payment relief.

Looking at the chart above, we can see how that type of thinking can be costly.

Adjustable Rate Mortgages Look Attractive When Compared To Fixed Rate Mortgages

The spread between fixed-rate and adjustable-rate mortgages continues to widen. 

45 days ago, the interest rate differential between a 30-year fixed and a 5-year ARM was marginal.  Today, the difference is dramatic. 

Several mortgage lenders, for example, are showing a full percentage point difference in mortgage pricing.  Against a $400,000 loan, that means that it's now $252.49 more costly to carry a 30-year fixed rate mortgage versus a comparable 5-year ARM. 

This is 4 times the payment difference you would have seen just a few weeks ago.

Fixed-Rate Mortgages Are As Risky As Adjustable-Rate Mortgages

In an article titled "Fixed-rate loans means no surprises", the Washington Post suggests that fixed rate mortgages are the safest mortgage choice for homeowners.

This is not true. 

This article is another example of the mainstream media ignoring the finer points of mortgage planning and home equity management.

The author talks about financial "safety" which I measure in three ways:

1. How liquid are your assets?
2. How diversified are your assets?
3. What is your assets' expected rate of return?

Against those benchmarks, the 30-year fixed-rate mortgage fails terribly.

First, the 30-year fixed rate mortgage includes a principal paydown in every mortgage payment.  Those principal dollars are sourced from a checking or savings account that is available at a moment's notice.  Once applied to the mortgage, those dollars can only be re-accessed with a remortgage.

Second, as the 30-year fixed rate mortgage pays down, the homeowner's real estate investment increases by the amount of principal paid down.  Every dollar put towards the home is a dollar in housing.

And third, the money used to pay down principal has been taken from a bank account where it was earning interest and is now just "money on paper" where it gains nothing. 

Summarized, the 30-year fixed-rate mortgage renders a homeowner:

1. Less liquid
2. Less diversified
3. Less wealthy

In other words, the 30-year fixed-rate mortgage fails on all three "safety checks".  It's the opposite of financial safety.

That said, there is a certain class of homeowners for whom the 30-year fixed-rate mortgages is appropriate, but it's not suitable for all.  That's why blanket statements like "fixed rate mortgages are safe" are false.

Like every other mortgage product, a 30-year fixed-rate mortgage should selecting only as it fits into a homeowner's short- and long-term financial goals. 

Fixed-rate loans mean no surprises
Kirstin Downey
Washington Post, October 1, 2006
http://www.washingtonpost.com/wp-dyn/content/article/2006/09/29/AR2006092901101.html

(Image courtesy: American Workwear)

Mortgage Rates Are Relatively Flat, From The 3-Year ARM To The 30-Year Fixed Rate

Mortgage rates are virtually identical on 30-year fixed rat programs as they are for 3-year adjustable rate mortgages. 

It's an uncommon event, but it makes sense if we consider the state of the economy.

• Short-Term: Explosive growth with a potential for elevated inflation
• Long-Term: Steady growth with contained inflation

All things equal, short-term mortgage rates (i.e. ARMs) should be higher than long-term rates such as the 30-year fixed because (1) the inflation risks are higher in the short-term, and (2) the need for banks to earn a greater return is higher in the short-term, too.

But all things are not equal. 

We have to consider the risk of time to traders of mortgage mortgage bonds.  As in: the more time that passes between now and some point in the future, the more chance there is of something unexpected happening.

Unexpected.  That word choice cracks me up because everything in finance and economics is based upon what is expected, not what isn't.  It's when the unexpected happens that markets go bonkers.

And this is why rates are flat like Kansas today.  Time Risk -- or the acknowledgement that something could go wrong in the future -- is offsetting Inflation Risk and its a complete wash.

(Image courtesy: Technotrekker)