Your Mortgage : They’rrrre Baaack: ARMs Are Booming

For the first time in 18 months, the economic equation has shifted in favor of home loans that many refinancers and buyers had virtually forgotten about: adjustable-rate mortgages.

That’s right, ARMs are back. In fact, they’re booming, thanks to a sea change in the bond market plus an undeclared price war among major lending institutions. Here’s what’s happening, and what it could mean to you as a potential borrower.

Everybody knows that interest rates have risen since February--a jump of about 1 3/4 percentage points for 30-year fixed-rate home loans. What you may not have noticed, though, is that short-term rates haven’t jumped as sharply--less than a percentage point during the same period. As a result, the spread or price gap between one-year ARMs and 30-year fixed-rate loans has hit its widest margin in over a decade--3 1/4 to 3 1/2 percentage points--according to HSH Associates, a Butler, N.J.-based firm that monitors rates nationwide. The typical spread historically has been 2 1/4 to 2 1/2 percentage points.

But the bulging three-point-plus price gap is only part of the story. In an effort to grab market share, highly competitive lenders have slashed prices on their ARM products, discounting them four points, five points and even more below comparable fixed-rate mortgage quotes.

For example, one large, nationally active thrift institution, Home Savings of America, based in Irwindale, is offering ARMs at a 2.95% start rate plus one point at closing. One point equals 1% of the loan amount. After the initial three-month introductory period, the loan rate is indexed to “11th District COFI”--the popular cost-of-funds index published by the Federal Home Loan Bank in San Francisco. COFI stood at 3.687% on May 1. On top of that index, Home Savings of America adds a 2 1/2 margin to compute the net interest charge on each loan. The fully indexed, current rate to the borrower, in short, is 6.187% (3.687 plus 2.5).

Substantial numbers of other lenders are plunging into the ARMs bazaar with their own aggressive pricing. Keith Gumbinger, vice president of HSH, said 20 lenders nationwide have posted current one-year ARM quotes of 3.75% or less. Dozens of others, he says, are in the 4% to 4 1/2% range.

“The gap (between these quotes) and anything available on the fixed-rate side is really wider than we’ve ever seen,” Gumbinger said. “This is attractive enough to make you stop and say, ‘Hey, maybe we ought to consider an ARM after all.’ ”

Which, of course, is precisely what price-warring lenders want you to do. But is a bargain-basement ARM the right option for you as a home buyer or refinancer this spring? To answer that you’ve got to do a little math.

Say you’ve got a choice between an ARM with a first-year rate of 4% and a fixed-rate 30-year loan at 8 1/2%. Assuming the up-front fees and points are the same on both loans, how do you figure which is better?

First, what index and margin come with the ARM? The most popular indexes are either the relatively volatile one-year Treasuries (4.9% the first week of May) and the slower-changing 11th District COFI discussed earlier (3.687%). Margins tend to average 2 1/2 to 2 3/4 percentage points. You need to focus carefully on these because your fully indexed rate (index plus margin) is what you’ll be paying after the initial sale-price period is over.

Next you have to ask about rate caps. Does the loan come with a 1 or 2 percentage point maximum rate increase ceiling per year, and a 5% or 6% lifetime cap?

Say the 4% loan quote comes with “2 and 6”--a two point yearly cap, 6% lifetime. You can now figure your worst case scenario on the loan: A 4% rate through spring 1995, a 6% rate through spring 1996, an 8% rate through spring 1997 and a 10% maximum rate thereafter. Your net savings from lower monthly payments during the first three years should keep you a winner on the loan through at least 1999--even if Congress and President Clinton totally blow economic policy and rates rocket into double digits. After that, the 10% cap rate versus the 8 1/2% fixed rate begins to cost you serious money.

That’s why even the deepest-discount 1994 model adjustables are best suited to buyers or refinancers who don’t expect to be in the same home--or on the same mortgage--for an extended period of years. If you don’t fit that bill, stick with a fixed rate.

Some advice for savvy ARMs shoppers, courtesy of HSH’s Gumbinger: Beware of low start rates that are paired with extra-fat margins--those above 2 3/4 percentage points. Margins of 3 and higher turn into money-gobblers once the loan is fully indexed.

Watch out, too, for extra high lifetime ceilings. Some go as high as 7 or 8 percentage points--taking you into the low teens worst case. Other ARMs have no lifetime caps at all, and can take you to the moon.