Everyone with one of these loans should make this choice:
First, ARM is an acronym for Adjustable Rate Mortgage. The most popular form of these loans was and still is referred to as a hybrid which means it combines both fixed and adjustable terms. Hybrid’s have an initial fixed portion of 3, 5, 7, or 10 years, then the loans converts to the adjustable portion, changing every 6 months or 1 year thereafter for the remaining term of the loan which is typically 30 years.
Some lenders sold these products as fixed rate loans, never discussing the adjustable portion with their clients. These clients, believing they have a fixed rate loan, may be in for a shock. But will that shock be a bad one?
Many consumers got one of these loans knowing they had the first few years as a fixed rate, planning to either move, move up or refinances. All of these options assumend a new loan which everyone figured would be available and likely at the same or slightly different rates. Currently, both of these choices can’t be easily done and likely won’t be for 1-2 years. Again a shock to the Silicon Valley mortgage holder. But will that shock be a bad one?
Al purchased a property in July of 2005 using a 5-1 ARM. His loan balance was $656,000, his interest rate was 5.75%, he has a 10 year interest only payment option which many of these loans had, and he has no pre-payment penalty. His plan was to take some of his equity, improve his property then sell it to buy a bigger home for his expanding family.
Al now has a breakdown! the improvements were completed in 2006 about 1 year after he got the loan. He planned to sell in mid 2008. Well that didn’t happen and Al is now looking at what to do. His loan rate will reset in July of 2010 to what ever rates are at that time according to the terms of the adjustable rate portions of his loan. His questions is should he reset or refinance now to avoid an uncertain future.
What Would You Do?
- Refinancing now, closing before the end of 2008, Al will get a 30 year fixed rate loan with full payments for about 6.375% an increase in monthly payments of about $1,035.
- Refinancing in January 2009 Al will get the same loan at an interest rate of about 7.25% with a payment increase of about $1,417.
- Al Could keep his existing 5.75% for another 20 months & take his chances when the loan Resets on getting the same or better rate in the adjustable portion. His loan has a 1 year treasury index whose value is currently 1.91, his loan has a margin of 2.75, and these two added together equal 4.66% which is where his rate would be if it adjusted today.
For these types of loans the most popular indices are:
- LIBOR - 6 month = 3.23%, 1 year = 3.34% - - 60% of US mortgages have this index
- Treasury Securities - 1 yr CMT = 1.91%, 12 month MTA = 2.47% - - 25% of US mortgages have one of these index values
- COFI & other regional bank issues - COFI 2.69% - - 15% of US mortgages have these index values
The vast majority of Margin values are:
- Prime loans or A paper = 1.875% - 2.75%
- Sub-Prime or B & C paper = 3.25% - 4.75%
There are other terms of your loan, your life, and the economy which must be considered when evaluating whether to refinance or reset like interest rate caps and pre-payment penalties. The costs of refinancing, your goals and plans for the future, stability of your credit and you employment, and most importantly what the expectations are for index values should also be considered when making these choices.
Al decided to refinance now and here’s how he chose:
- He’s guaranteed to get a fixed rate loan below 7%
- He is not paying costs out of pocked, they are all included in the new loan preserving cash
- His current job is secure and he is mildly concerned about the future of his company which could negatively impact his qualifications to get a new loan
- He is concerned his home may drop in value making it impossible to refinance
- Index values are low right now but as the economy recovers and expansion takes hold, they will rise, increasing the risk he will pay higher rates when his loan resets.
- Even though Al considers himself aggressive in taking risk, he felt that now is a time to adopt a more conservative approach with so much uncertainty at hand.
The San Jose Mercury ran an article last week about these mortgages that is worth reading. To see it click here
To learn more about or see current index values & their movement see Mortgage-X
If you’re concerned about your situation, put it in a comment or drop me a line Contact Dan
