Adjusting to Change : Rising Rates Shift Trend Away From Fixed Mortgages

Adjustable-rate mortgages are making a comeback, thanks to the recent sharp rise of rates on fixed-rate loans.

Most new home loans being taken out now are adjustable-rate mortgages, a turnaround from a few months ago, when they were primarily fixed-rate, lenders say. Home Savings of America, one of the nation’s biggest lenders, says 89% of its new mortgage applications are for adjustable loans, compared to 23% a year ago. There has also been a substantial surge in applications for adjustable loans at Great Western Bank, said Sam Lyons, a Great Western senior vice president.

The reason for the switch is clear. The cost of fixed-rate mortgages has skyrocketed in the past two months, with rates jumping between 1 1/2 and two percentage points just since February. Adjustable loan rates have also risen, but not nearly as much.

The average rate nationally for 30-year fixed mortgages jumped to 8.6% in mid-April from a low of 6.8% in October, according to HSH Associates in Butler, N.J. Adjustable loans have risen by about one percentage point over the same period and now average 5.1%.

“It’s an affordability issue,” said John J. Lewis, managing editor of Inside Mortgage Finance, a Bethesda, Md., industry newsletter. “People are concerned about what their monthly payments are going to be. If you can get an adjustable loan at 4% or 5%, that’s a big advantage over an 8% fixed rate.”

But consumers need to realize that unlike fixed-rate loans, for which the main issues are interest rates and fees, several important variations exist between the different types of adjustable mortgages, including the index, adjustment periods and interest rate caps. And because it’s difficult to keep an eye on all of these factors, there are some common misperceptions about the “best” adjustable loans to obtain.

For example, many consumers believe that the best adjustable loan in today’s rising rate environment is the one that’s tied to the slowest-moving index, the 11th District cost of funds index (COFI). It and the one-year Treasury bill index are, by far, the nation’s most popular indexes for adjustable loans, accounting for 31.4% and 42.8% of the market, respectively, according to the Federal Housing Finance Board in Washington.

The COFI index moves slower largely because it is based on the borrowing costs of savings and loans in California, Nevada and Arizona; borrowing costs typically move slower than the one-year Treasury bill. The idea is that you’ll feel interest rate hikes much more slowly with a COFI loan than with the faster-moving one-year Treasury bill index.

Better yet, COFI loans also typically come with lower start rates and lower “margins.” The margin is the amount you must pay over the index. For instance, if the index is 3% and the margin is 2.5 percentage points, you would pay 5.5%.

The combination of lower start rates and margins can make COFI loans look like a tremendous bargain.

But in reality, when interest rates are rising, COFI loans can cost you substantially more than adjustable loans tied to Treasury bill rates. Why? Adjustment periods and interest rate caps.

The typical T-bill loan adjusts just once a year, has a two-percentage-point annual interest rate cap and a six-percentage-point lifetime cap. In other words, a loan that starts at 4% can jump to a maximum of 6% in year two, 8% in year three and 10% in all subsequent years.

The typical COFI loan, on the other hand, adjusts monthly and has a lifetime interest rate cap but no annual interest rate cap. Theoretically, at least, you could jump from a low introductory rate to a very high rate in a short period.

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To illustrate how that works out in real money, let’s look at two hypothetical borrowers, Sally and Mike, who took out $150,000 adjustable loans in mid-April at Great Western Bank. (Loan rates and fees change daily.)

Sally opts for the COFI loan, which offered an introductory rate of 3.55% for three months. After that, the loan rate would float 2.35 percentage points above COFI, which was at 3.69% when the loan was secured.

Mike takes the T-bill loan, which offered a 4% introductory rate for one year and would then float 2.75 percentage points above the one-year Treasury index, which was at 4.32%.

What happens to Sally and Mike if interest rates rise over the next five years at the same rate they fell during the previous five years? Even though Sally starts at a lower rate and her index is rising more slowly than Mike’s, she pays $9,302, or about 14%, more over the five-year period.

Worse still, if interest rates stay high, she’ll pay more every year for as long as she maintains the loan.

Why? Sally’s rate is “fully phased in”--banker jargon for the fact that the introductory rate is over and she’s paying full-fare based on the index plus the margin--in the fourth month of the mortgage.

Mike gets the low introductory rate for one full year. In the second year, he gets the benefit of the two-percentage-point interest rate cap. Mike’s rate should have jumped to 6.25% in the second year, but because of the cap, it only rose to 6%.

In years three and four, Mike gets locked in at the going rate at the anniversary date, which, in a steadily rising rate environment, is the lowest rate of that 12-month period. Meanwhile, Sally is paying somewhat more each and every month.

They both hit their interest rate caps in the fifth year, but Mike’s cap is set at 10%, while Sally’s is at 10.95%.

Does that mean the T-bill index is better? Not necessarily. A few lenders offer annual interest rate caps and longer adjustment periods on COFI loans. When these loans are offered at competitive interest rates and fees, they could prove the least expensive of all.

A Call to ARMs

The vast majority of adjustable-rate mortgage borrowers choose loans that are tied to the one-year Treasury bill index or to the 11th District cost of funds index (COFI), according to the Federal Housing Finance Board in Washington. Here are the pros and cons of ARMs tied to the one-year Treasury bill index versus the COFI:

ONE-YEAR TREASURY BILL

* Pro: Annual and lifetime interest rate caps of 2 percentage points and 6 percentage points, respectively, provide some protection against rapid interest rate hikes.

* Con: A 2 percentage point hike can be substantial, subjecting borrowers to payment shock. On a $200,000 loan, the payments would rise by nearly $270 when going to 8% from 6%.

* Pro: Terms of T-bill loans are usually fairly standard, which makes it easy to compare rates at several financial institutions.

* Con: These loans are frequently sold to other lenders or into the secondary market, which makes it difficult to alter the terms of the loan if you ever need to.

11TH DISTRICT COST OF FUNDS

* Pro: Lenders are often more flexible when qualifying COFI borrowers, allowing individuals to take out somewhat bigger loans.

* Con: The interest rates on these loans typically adjust more frequently, which can be costly.

* Pro: To guard against payment shock, some lenders have payment caps, meaning your monthly payment can’t rise above a set amount regardless of what happens to interest rates.

* Con: Payment caps lead to something called “negative amortization,” meaning that your loan balance actually grows with each payment because you’re not paying enough to cover the principal and interest expense each month.

HOW THE INDEXES PERFORM

The 11th District cost of funds index tends to move more slowly than the one-year Treasury bill index. Quarterly closes, except latest:

4th, 1993 Treasury bill index: 4.73% Cost of funds index: 3.69%

Source: Federal Housing Finance Board; Bloomberg Business News