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Archive for Sunday, December 18, 2005

ARMs losing favor

How to survive jump in variable mortgages

December 18, 2005

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First, the bad news: If you're among the millions who took out an adjustable-rate mortgage in the past few years, your monthly payment is likely to jump on the next adjustment date - by 20 percent, 30 percent, even 40 percent. Blame the Federal Reserve for driving up short-term interest rates.

But there's good news, too: You still can get a good deal refinancing to a 15- or 30-year fixed-rate mortgage. Thank the bond market, which has defied the Fed and kept long-term rates low.

ARMs have been hot for the past couple of years because their low first-year payments allowed homeowners to borrow more as home prices soared. Now it's time to pay the piper.

The typical ARM adjusts every 12 months by adding a "margin" - often 2.75 percentage points - to an underlying index, such as U.S. Treasury notes with one year left to maturity.

A year ago, those notes carried rates around 2.6 percent. So an ARM that adjusted at that time has probably charged to about 5.35 percent.

The string of Fed rate hikes since June 2004 has driven the one-year Treasury to about 4.34 percent today. So an adjustment now would go to about 7.1 percent - a 32 percent increase.

On a $200,000 loan, the monthly principal and interest payment would jump from $1,117 to $1,358.

Many people who took out ARMs in 2004 at rock-bottom "teaser" rates of 4 percent or less now will see their rates soar by 50 percent. (Most ARMs limit adjustments to 2 percentage points a year and 6 points over the loan's life.)

As I said, the good news is you can still get a 15-year, fixed-rate loan for around 5.5 percent, and a 30-year one for just under 6 percent.

Figure how much you can save per month by refinancing. If you'd have the new loan long enough for that saving to offset the refinancing costs, do it.

Remember that the Fed probably is not finished raising short-term rates, so your ARM could go even higher a year from now. If you wait until then to refinance, fixed-rate loans may be charging more as well.

There's another way to tackle the problem: by making a big principal payment, reducing the size of the loan and thereby cutting the monthly payment at adjustment time.

ARM payments are figured by applying the new interest rate to the remaining loan balance and term.

Suppose, for example, you were five years into a 30-year ARM and after 60 payments had paid off $20,000 of the $200,000 you'd borrowed. The new payment would be figured by applying the new rate against $180,000 for 25 years.

But if you paid an extra $30,000 to principal before the adjustment, the new rate would be applied to a $150,000 balance for 25 years. Obviously, the payment would be smaller.

This possibility often is overlooked because most borrowers are more familiar with fixed-rate loans. With those, extra principal payments do not reduce the required monthly payment; the benefit instead comes from paying off the loan faster.

Of the two approaches, refinancing probably is best because it means locking in a relatively low fixed rate. Paying down principal will cut your monthly payment, but you'd still risk facing higher payments later if interest rates continue going up.

To figure the best course, use a mortgage calculator. There are good ones at www.bankrate.com and www.hsh.com.

Jeff Brown is a business columnist for The Philadelphia Inquirer.

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