Mortgage rates inch down; borrowers embrace ARMs
By Holden Lewis • Bankrate.com

There are several good reasons to get an ARM. Here's one bad reason: Because 30-year fixed-rate mortgages have risen above 6 percent. That's short-term thinking.

The benchmark 30-year fixed-rate mortgage fell 2 basis points to 6.35 percent, according to the Bankrate.com national survey of large lenders. A basis point is one-hundredth of 1 percentage point. The mortgages in this week's survey had an average total of 0.34 discount and origination points. One year ago, the mortgage index was 6.31 percent.

The benchmark 15-year fixed-rate mortgage fell 4 basis points to 5.68 percent. The benchmark 1-year adjustable-rate mortgage rose 3 basis points to 4.14 percent.

Just two months ago, 30-year fixed-rate mortgages were hovering below 5.5 percent. The week of June 11, Bankrate.com's mortgage index dipped to a modern low of 5.28 percent. Until late July, the average rate on a 30-year fixed mortgage had not exceeded 6 percent all year. Borrowers grew accustomed to these low rates, forgetting that they're usually much higher.

Since 1985, when Bankrate.com began its weekly mortgage survey, the 30-year fixed rate has averaged 8.40 percent. Since 1990, it has averaged 7.75 percent; in the last 10 years, 7.37 percent; and in the last five years, 7.06 percent.

Viewed in that perspective, getting a fixed-rate home loan at between 6 and 6.5 percent is nothing to complain about. But many borrowers disagree. Almost one quarter of mortgage applications last week -- 23.3 percent -- were for ARMs, according to the Mortgage Bankers Association.

Typically, ARMs are popular when fixed rates are high and borrowers feel confident that they will head down. Neither is the case right now.

"Don't let your ego -- bragging about your low rate today -- blind you to the fact that, two or three years from now, your rate will be much higher than today's fixed rate," says Brian Peart, president of Nexus Financial, a mortgage brokerage in Atlanta.

There are scores, maybe even hundreds, of ARM products out there -- anything from interest-only loans that adjust monthly according to changes in the London Interbank Offered Rate, to relatively conservative five-year ARMs that are indexed to the one-year Treasury bill.

ARMs, say experts such as Peart, are fine for people who don't plan to own their houses very long and for wealthy people who have complex financial lives. If you can't concisely explain to a skeptical friend why you're leaning toward getting an ARM, consider getting a fixed-rate loan.

When comparing fixed-rate loans, you have two main components to compare: rate and closing costs. With an ARM, you have five things to assess: the starting rate, closing costs, the index, margin and annual and lifetime caps.

The starting rate and closing costs are self-explanatory. The index is another interest rate that the ARM's rate is based on. The index could be the yield on the one-year Treasury or on passbook savings account rates on the West Coast (called the 11th District Cost of Funds Index, or COFI) or one of a myriad of other rates.

The margin is the percentage that's added to the index to arrive at the ARM's interest rate. An example: Let's say your ARM is indexed to the one-year Treasury bill. The margin is 2.75 percent. The yield on the one-year Treasury is 1.30 percent. You add the 2.75 percent margin to the 1.30 percent Treasury yield to arrive at an ARM rate of 4.05 percent.

This means that if two loans are tied to the one-year Treasury yield, and one has a margin of 2.75 percent and the other has a margin of 2.875 percent, the lower margin is a better deal because it results in a lower ARM rate.

The annual cap is the percentage that the rate can change in one year -- usually 2 percentage points -- and the lifetime cap is how high the rate can go over the life of the loan. That number often is in the double digits.

Assume that an adjustable-rate mortgage will rise by its annual cap the first time it adjusts, Peart advises.

For a large set of middle-class borrowers, one type of ARM makes sense: hybrid ARMs. These are mortgages in which the rate is fixed for the first three, five, seven or 10 years of the loan. They adjust annually after that initial period is over.

Hybrid ARMs are great for people who know that they will sell the house in a few years. For example, a five-year ARM, which has a low initial rate that last for five years, then adjust annually after that, might be perfect for an executive who knows he will be transferred to another city in four to six years, or for a young couple who plan to have children and move to a bigger house in a few years.