With all the nasty economic news around these days, it’s hard to be optimistic. Foreclosures are at all time highs, default rates are up, home sales figures are in the tank, and more and more areas are showing year-to-year declines in housing values. So what’s the good news?
Short-term rates are down which means that ARM loans, which are all tied to some kind of short-term index, are down too. These changes in rates were started in the marketplace before the Fed took its most recent With its .75% cut in the Discount Rate, all it is doing is acknowledging that rates are dropping and they are going along with it. It may be conventional wisdom to think that what the Fed affects mortgage rates, but it just isn’t true. The man in the street doen’t know what is going on in the market, but he can read the newspaper, so he thinks that it is because the Fed lowered rates. Whatever, the bottom line is that this is good news for people with ARMs. Here’s how.
A concern has been that non-subprime ARM loans that are resetting in 2008 will add to the problems of resetting subprime loans and Option ARMs. This is now less of a problem. For example, the 1 year CMT index that is commonly used in ARMs has fallen from 5% a year ago to 3.26% today. Here is what that means to borrowers.
A borrower with a 5/1 ARM taken out 6 years ago that reset in January 2007 was faced with a dramatic increase. The original note rate in 2002 would have been in about 5% with a margin of 2.75%. So when it adjusted a year ago, the note rate would have been 5% + 2.75% = 7.75%. That would require a much higher payment, almost 40% higher than the initial rate. And that’s for an A-paper loan to borrowers with good credit.
Today, however, with the index having fallen to 3.26, the note rate would only be 6%. That’s still an increase of 18% but more manageable. 6% has always been an excellent rate for mortgages and, frankly, if a borrower can’t afford that, he shouldn’t have bought in the first place.
You can see that the millions of these loans that will be resetting are not going to pose additional threats to the economy. But this news affects only borrowers whose loans are tied to the 1-year Treasury index. Many other loans are tied to 6 month LIBOR and the 11th District Cost-of-Funds indices.
These are stubbornly higher because rate in Europe where the LIBOR (London Interbank Offered Rate) is not directly tied to the U.S. interest rate market. That index is 4.6% but even with a lower margin, typically 2.25%, the resulting note rate would be 6.85%. The COFI index, always a slow moving index, will come down slowly too. It is now at 4.17% so with a margin of 2.25% the note rate would be 6.42%
Regardless of which index is used, you can see that the end result is still an interest rate that starts with a 6, much better than one that starts with an 8.
What does this mean for subprime and Option ARM borrowers? The margins on these loans is higher than the ones we have just discussed, but still the rates will be lower. And it makes it easier for a lender to negotiate something that is better for the borrower and yet which is in line with what the investors who own the loan are seeing in terms of general market rates.
The problems caused by profligate lending aren’t going to go away any time soon, but at least it solves a potential problem for some borrowers and makes renegotiation more likely for others.
A final word of advice. Fixed rate mortgage rates are as low too. 15-year fixed Conforming loans are actually below 5%, almost as good as they were back in 2002 and 2003 when the refinance boom was on. It’s shaping up to be another banner year for refinancing and it always makes sense to get out of any ARM and into a fixed rate loan when rates are down. If you have an ARM, I would take this opportunity to get off the roller-coaster.
Randy Johnson – Author of How to Save Thousands of Dollars on your Home Mortgage and Savvy Borrower
articles. Randy is a mortgage broker who has financed over $1 billion
in properties. He writes about home buying and real estate finance
topics for CreditBloggers.com.
Randy Johnson Randy is a Credit.com contributor and seasoned mortgage expert. He writes about home buying, mortgage laws and real estate finance issues. He has financed over $1 billion in properties, is the author of How to Save Thousands of Dollars on your Home Mortgage and he is a feature columnist for Savvy Borrower.
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Excellent info Randy!