Can lower rates make ARMs attractive again for mortgage borrowers?

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If you think mortgages rates will continue to fall, is now the time to get an adjustable-rate mortgage, an ARM?

This may seem like an odd question in an era of super-low fixed mortgage rates. One result is that ARMs are simply not popular. According to Ellie Mae, ARMs represented just 2.4 percent of all mortgage originations in October, down from 6.3 percent in June 2019.

No doubt about it, a lot of people are grabbing fixed-rate mortgages while rates are low and refinancing can mean big monthly savings. But perhaps ARMs are being overlooked. Maybe there’s a case to be made for financing with adjustable rates.

Falling mortgage rates and ARMs

The big ARM worry is rate shock. ARM rates can rise and fall. No one wants to be in a situation where a sudden rise in monthly costs makes the loan substantially less affordable or not affordable at all.

ARMs use rate caps to prevent payment shock. There can be initial, annual and lifetime rate caps. But keep in mind that the marketplace has generally been kind to ARM borrowers.

Mortgage rates have been falling for decades. Not every moment and not every week, but the trend has been down, down, down since 1981. That’s the year mortgage rates averaged 16.63 percent versus 3.94 percent in 2019, according to Freddie Mac.

The average mortgage rate for 2020 will be lower still. Freddie Mac figures show that for August, September and October the typical mortgage was priced below 2.9 percent. Despite a pandemic, the worst unemployment situation since the Great Depression, massive fires, numerous hurricanes and a combative political environment, the odds are that 2020 will have the lowest mortgage rates since Freddie Mac began collecting data in 1971.

The Mortgage Bankers Association expects mortgage rates to climb in 2021, a forecast that reflects the consensus view. But as low as rates are, they can certainly go lower. “While interest rates and mortgage rates are low now, there can be a case for ARMs and potentially even lower interest rates than we have now,” says Craig Kirsner Stuart of Estate Planning Wealth Advisors in Coconut Creek, Florida

“When we have the next crash and recession,” adds Kirsner, “the government will probably do the same thing over again: lower interest rates and inject more stimulus into the economy.”

Start rates for ARMs

ARMs have traditionally been offered with start rates below the interest levels for fixed-rate financing. The reason is that lenders want borrowers to finance and refinance with adjustable rates to offset inflation.

Today, however, the advantage of lower ARM start rates is gone. On Nov. 19, for example, Bankrate reported that fixed rate loans were typically available at 2.96 percent while 5/1 ARMs were priced at 3.03 percent. The difference between the two rates is small but important. A $300,000 mortgage at 2.96 percent interest has a monthly cost for principal and interest of $1,258.35. An ARM with a 3.03 percent start rate will have an initial monthly cost of $1,269.67. That’s a difference of $11.32 a month or $135.84 a year.

Since a 5/1 ARM has a fixed rate for the first five years, the additional cost is $679.20 during the ARM’s start period. Would you pay more for ARM financing? Some borrowers might, perhaps believing that an ARM will allow them to capture a lower future rate without the expense of refinancing. Or, some borrowers might prefer an ARM because qualification standards are more liberal, thus increasing the chance to get financing.

ARMs and rate risk

The importance of generally falling mortgage rates is that they offset a fundamental ARM risk. If you get fixed-rate financing, your monthly cost for principal and interest is set for the life of the loan. If you get an ARM, the rate can change. That means the monthly cost for principal and interest can rise and fall.

Rising rates are a potent ARM problem, especially if rates rise when borrowers have less income — think of all the lost jobs recorded in 2020. However, if rates are generally falling — as they have been for nearly 40 years — then maybe the risk of rising rates is not so worrisome. This seems logical, but as they say on Wall Street, past performance does not guarantee what will happen in the future.

Discussions regarding rate risk and ARMs usually ignore the reality that there is also rate risk with fixed-rate mortgages. If interest levels are falling and a mortgage rate is fixed, the borrower may want to refinance to get a lower rate. That costs money, and you need to be qualified.

Forget about rates in the 2 percent range. What if rates go lower? Far lower. Think about mortgage rates never seen in the U.S., submarine rates, rates so low that lenders have to reprogram computers. Is it possible that if mortgage rates fell into a huge financial pit that ARM borrowers might end up with a mortgage rate of zero or even a negative rate, a rate forcing lenders to pay borrowers? This has actually happened in Europe.

The ARM lifetime floor

ARMs traditionally have not had a minimum rate. This changed in 2016 when Freddie Mac established a “lifetime floor” interest level, the lowest a rate could go. Fannie Mae followed suit in 2017. The ARM lifetime floor is now commonly equal to the loan’s margin.

ARM interest rates combine an index and a margin. The index moves up and down according to independent measures such as the movement of the prime rate, the LIBOR (the London Interbank Offered Rate), or Treasury securities. The margin is a fixed number.

Let’s say you look at a 5/1 ARM. With this form of financing the rate is fixed for the first five years of the loan term. Thereafter, it can move up or down once a year. The loan might be set up with a 2.85 percent start rate. It might also have a 2.25 percent margin. This means the index is at .60 percent. (2.25 percent plus .60 percent = 2.85 percent)

  • If it happens in five years that the index moves down to .40 percent the new rate will be 2.65 percent.
  • If the index moves up to 1 percent the new rate will be 3.25 percent.
  • If the index falls to 0.00 percent the new rate will be 2.25 percent.
  • If the index goes negative, if it goes to -.25 percent, the new rate will still be 2.25 percent under the lifetime floor rule.

Bottom line

It is entirely possible that mortgage rates can go lower. ARM rates can fall but the ability of ARM interest levels to go lower is limited by lifetime floors. Borrowers with an interest in ARMs should look for the lowest possible margin as well as the best start rate and smallest caps when shopping for an ARM.

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Written by
Peter G. Miller
Contributing writer
Peter G. Miller is a contributing writer at Bankrate. Peter writes about mortgage rates and homebuying.
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