Fall Real Estate 2006

Publication Date: Friday, October 13, 2006

ARM twisting
It may be time to switch from adjustable to fixed-rate mortgages

by Dan Shilstone

A buyer straining to afford a home in the intimidating Palo Alto real estate market might find the low monthly payments of an Adjustable Rate Mortgage, or ARM, an attractive alternative to the higher initial costs of a standard fixed-rate loan. But rapidly rising rates are making homebuyers reconsider.

Three years ago, when interest rates were at historical lows, the savings offered by ARMs drew buyers in unprecedented droves. Now, as the first major wave of rate adjustments has hit since this ARM boom, the advantages of an adjustable rate loan are not so clear.

In basic terms, an ARM is a loan that the borrower agrees to pay off at a certain interest rate for a specified period of time, after which the interest rate is subject to scheduled adjustments (up or down) based on current market trends. Like common fixed-rate mortgages, ARMs are designed to be paid off monthly over a period of 15 or 30 years.

Monthly payments, however, are subject to change in accordance with the two-number adjustment schedule attached to a specific ARM (usually 1-1, 3-1, or 5-1). The first number signifies, in years, the initial period during which interest is fixed, and the second number signifies how often the rate is subject to change once the initial period has lapsed. So a 3-1 ARM, for instance, might have unchanging monthly payments of $4,000 for the first three years, after which payments could rise to $4,500 to reflect current interest rates. Payments are now fixed at $4,500 for the next year, after which they could increase again or drop, say to $4,300, depending on interest rates. Payments undergo such yearly adjustments for the remaining life of the loan.

An ARM's interest rate can be tied to any one of a number of indexes, but those most commonly used are the one-year U.S. Treasury bill, the London Interbank Offered Rate (LIBOR), and the 11th District Cost of Funds Index (COFI). Each index fluctuates continually in response to the ups and downs of the economy, but changes in ARM rates are based on the current value of the index at the time of adjustment.

So ARMs do carry some element of risk. The 3-1 ARMs that are now reaching their first adjustment period are doing so in an economy where interest rates are not as low as they were three years ago, and the result will be a sudden increase in monthly payments. If payments increase to unaffordable levels, residents may be forced to sell their homes or go further into debt.

Even a .25 percent increase in rates can mean more than a $100 increase in the monthly payment on a $1,000,000 loan (which is an average loan in this market). Going from 4.5 percent to 6.5 percent, as many 3-1 ARMs could do in the next year, would mean a monthly payment of $5,066.85 increasing to $6,320.68. And while some ARMs place limits on the amount a payment can increase in any one adjustment period, such adjustment caps can be deceptive: If caps have artificially kept a payment below the interest due, unpaid interest may be added to the amount of the original loan, increasing debt even though payments are being made.

Matt Rohrbach, a loan officer with Stanford Mortgage, Palo Alto, does not feel it's time to start panicking, however, reminding that "although interest rates are not what they were a few years ago, historically speaking, they're still quite, quite low. ...Payments will go up a little, but I think people will stretch and make it work." He suggests, however, that for those committed to their homes in the long term, this may be a good time to convert to a fixed-rate mortgage.

Rick Stern of Stern Mortgage, Palo Alto, agrees. "This is really unusual. I've been doing this for 28 years and I've never seen it quite like this. Fixed rates have not moved up as much as the adjustable rates have. The fixed rates have stayed pretty stable. They're terrific, in my opinion." At rates as little as .25 percent more than an ARM, and without the risk of increases, he feels fixed-rate mortgages make a lot of sense for those looking to secure a long-term home.

So are ARMs simply an unnecessary risk in the current market? Stern doesn't think so. "It depends on a person's needs. If you're getting into a property today and you expect to be out of that property in three or four years, you could save that quarter percent. Most of the people come into my office and say they're going to be in their home forever, and I tell them, no, you're not. The fact is that the average American keeps a loan for less than four years."

And with appreciation rates over the last five years being, in Rohrbach's words, "outrageous," many people can take equity out of their homes to offset any rise in ARM rates.

"Or you can sell your house and walk away with $300,000 you never would have had," he said. "An ARM is just a tool. You want to use the right tool for the right job."

Right now, Stern and Rohrbach agree the best tool for someone looking to acquire a long-term family home is probably a fixed-rate mortgage, while someone who has followed a job to Palo Alto and could follow a better job somewhere else in a few years may find that an ARM is a more suitable tool. It is important to rationally assess personal needs, rather than rush into the loan with the cheapest initial payment plan, they said.

Even interest-only and 1 percent loans have their uses, but are generally for more sophisticated buyers. "I get infuriated with how they're sold," said Rohrbach. "'Wow, I can save you a TON of money!' they say, but with those low payments, what they don't tell you is the balance gets larger and larger." He warns that there are plenty of predators pushing low-interest loans on the uninformed, so the buyer should always beware, but also understand that legitimate ARMs have their uses.

"I would venture to guess that people have paid less, in the long term, with ARMs," said Stern. "Since 1989 they've crept down and down and down until a year and a half ago they started creeping back. It's important to realize that history is no indication of what the future may bring. They'll go up and down and stay the same, but not necessarily in that order. We never know what's going to happen next. I guess that's part of what makes it fun."

Editorial intern Dan Shilstone can be reached at dshilstone@paweekly.com.