ARMs are looking better as the spread widens
By Michael D. Larson • Bankrate.com

Adjustable-rate mortgages are supposed to offer borrowers lower rates during the first year or more of their loans. After all, customers are taking on the risk that interest rates will rise, along with their payments, down the road.

But during the latter half of 2000 and the first quarter of this year, that wasn't the case. Because of the timing of the economy's downturn and the Federal Reserve Board's rate cuts, ARM rates were so close to long-term fixed rates that borrowers had little reason to get adjustable-rate loans.

ARM deals expected to increase
Over the past couple of weeks, however, that situation has changed. Most experts think the ARM outlook will continue to improve, too. That means mortgage hunters can start shopping for ARMs again without worrying about getting ripped off.

"ARMs offer consumers the ability to obtain a mortgage where the mortgage interest rate over the next year or perhaps the next couple years is below what you'd have to pay on a fixed-rate mortgage," says Frank Nothaft, deputy chief economist at Freddie Mac in McLean, Va. "The ARMs traditionally are priced well below the fixed-rate product, but January was a real aberration.

"With the rate cut we had (April 18)," he adds, "it's pretty clear to me we're going to see that spread widen between ARMs and fixed rates."

ARMs have always attracted certain home buyers, such as people who don't plan to live in their homes for long and first-time buyers who need extra help qualifying for home loans. That's because ARMs provide lower "teaser" rates and lower payments for an initial fixed period. After that period ends, most have rates and payments that adjust annually. Ideally, borrowers use the first one, three, five, seven or 10 fixed-rate years to invest or save up money for the higher payments that almost always await them once the variable-rate period begins.

But when ARMs don't have low enough teaser rates, they offer borrowers practically nothing. Consumers take on the risk of rising rates, but receive little financial reward from their lenders for doing so.

That was the case for most of 2000 and the first quarter of 2001. Beginning in May, the spread between one-year ARM rates and 30-year fixed rates narrowed substantially. The first week of January, it was 11 basis points, or .11 percent, the narrowest ever recorded by Bankrate.com, which has mortgage data going back to 1985. Over the past 16 years, the average spread is 1.99 percent.

Rates got that way because long-term mortgage rates fall in anticipation of Federal Reserve Board rate cuts, while short-term mortgage rates don't fall much until those cuts start happening. Between mid-September and early January, for instance, 30-year fixed rates dropped all the way to 7.07 percent from 7.95 percent even though the Fed didn't cut rates until Jan. 3. During that same time, one-year ARM rates fell to just 6.96 percent from 7.27 percent.

"When you have a very small differential between a short-term, say, one-year rate, and a 30-year fixed, I think you really have to think long and hard about the advantages of taking a secure rate that's fixed for 30 years, particularly when you're in a relatively low-rate environment," says Dan Duggan, senior vice president at HSBC Mortgage Corp. (USA) in Depew, N.Y.

"It's somewhat of a common sense decision."

As the spread widens
Since the beginning of the year, though, the situation has improved for ARM shoppers. In the past few weeks, the pace of improvement has increased, too.

Why? The "anticipation effect." Investors have started betting the Fed's rate cuts will get the economy going again and that eventually, the Fed will have to start raising rates as a result. That has kept long-term rates fairly stable to slightly higher. At the same time, most don't think the Fed has finished cutting rates in the current cycle. That has sent short-term rates lower. The result is that the yield curve is starting to look like it should again and mortgage pricing is returning to normal.

For ARM shoppers, this is good news. While spreads aren't back to their historical norms, they're headed in that direction. As of April 18, the spread between one-year ARM rates and 30-year fixed mortgage rates had widened to 87 basis points. That was the biggest gap since July, according to Bankrate.com data, and experts say further widening is likely.

"We've had a series of rate cuts since (January), which has reduced short-term interest rates and when short-term rates decline, so do ARM rates," says Nothaft of Freddie Mac. "We should see further moderations in the start rate on adjustable-rate products in the coming weeks."

Because of that, another expert says, ARM shoppers who can afford to wait a little longer to get a loan may want to do so. There's a good chance they'll be rewarded with even lower teaser rates down the road.

"There's not enough yield differential yet," says Carroll Justice, executive vice president of capital markets at First Horizon Home Loans of Irving, Texas. "But we've had a significant steepening of the yield curve and that should start pushing the differential out.

"Over the next few months, we're going to start seeing it."