The Great Rate Debate

By Liz Pulliam Weston

June 2, 2000 12 AM PT

Pity the poor home buyer trying to choose between an adjustable-rate or a fixed-rate mortgage right now.

Two years ago, the issue was almost a slam-dunk. Fixed-rate mortgages had hit generational lows; the conventional wisdom was that interest rates had nowhere to go but up, which made locking in low fixed-rate loans seem like the only smart move.

Indeed, fixed-rate mortgages have gone up--significantly. After bottoming at around 6.1% in October 1998, 30-year fixed mortgages now average about 8.54% nationwide, down just slightly from their recent peaks.

Higher fixed rates mean that more families are getting priced out of the homes they want. And that makes the lower starter rates of adjustable-rate mortgages seem more attractive. The average one-year ARM now offers a beginning rate of 7.25%.

But many experts say that ARM starter rates are not far enough below fixed rates to make the risk of future higher payments worthwhile.

For most buyers, one-year ARM loans tend to be a better deal than fixed-rate loans when the ARM “teaser” rates are 2 to 3 percentage points below comparable fixed rates. Currently, however, one-year ARMS are less than 1.5 percentage points cheaper.

If market interest rates a year from now are just as high, or higher, than current rates, ARMs taken out today could quickly become far more expensive than today’s fixed-rate loans.

“The one-year ARM is the highest it’s been since 1991. And there’s not much possibility rates are going to go down in the next year,” says Greg McBride, analyst with Bankrate.com, a consumer financial information site that tracks rates. “You’re really rolling the dice if you go with the one-year.”

You can blame the Federal Reserve, and the vagaries of the bond market, for the mortgage situation right now. Short-term rates are higher largely because of the Fed’s efforts to head off inflation; long-term rates have gone up less mostly because of bond traders’ confidence that the Fed will succeed in the long run.

But opposition to ARM loans isn’t universal among experts.

Earl Peattie, president of Mortgage News, is one who says even one-year ARMs can make sense for some buyers now. Peattie says that the savings from an ARM’s first-year teaser rate could offset higher payments in the second and even third years of the loan.

And he points out that there are scenarios that could mean lower interest rates a year from now--an economic slowdown, for example.

Buyers who expect to live in their homes for only a few years, and who believe they could handle higher payments later, might want to take a gamble on a one-year ARM, Peattie says.

The issue of whether ARMs beat fixed-rate mortgages is more than academic for borrowers who opted for one-year ARMS last year--and who are now beginning to get a taste of how painful higher rates can be.

Someone who took out a $200,000 ARM in April 1999, when teaser ARM rates averaged 5.87%, for example, has been making monthly payments of about $1,182. That’s $86 a month less than if the borrower had gone with a fixed-rate loan at 6.53%.

Now, with the jump in interest rates, that ARM borrower is facing a $1,444 monthly payment, or $176 more than the fixed-rate loan.

The bigger payment assumes the ARM adjusts once a year, with the new rate determined by adding 2.75 points to the one-year Treasury bill rate on the loan’s anniversary date. The example also assumes that the total loan rate adjustment is capped at 2 points per year.

In the current market, many mortgage experts suggest that hybrid ARMs, which offer fixed rates for three to 10 years before switching to a one-year adjustable loan, are a better option.

These loans offer initial rates that are higher than one-year ARMs but lower than 30-year fixed rate loans. The longer the initial fixed period, the lower the discount offered compared with the 30-year.

Borrowers can match the length of a hybrid loan’s fixed period to the length of time they expect to live in the house--or gamble that rates will fall enough to make refinancing worthwhile after the initial fixed period expires. But many hybrid and adjustable-rate loans include prepayment penalties that make early refinancing expensive.

And there’s always the risk that things won’t work out as planned.

“The guy who got a three-year [hybrid] ARM three years ago might have thought he could refinance at a better rate” when the fixed portion of the mortgage ended, McBride said. But the markets, and the Fed, haven’t cooperated.

People can get stuck in homes much longer than expected, as well. Some Southland neighborhoods are just now recovering from the real estate recession of the early 1990s that trimmed 20% or more from home values. Many people who expected to sell their homes in a few years for a fat profit instead found themselves “underwater,” with homes worth less than the outstanding mortgage.

The bottom line: Borrowers should not assume one type of loan is better than another until they actually compare rates, costs and payment scenarios for their specific situation, Peattie said. The Internet is filled with calculators designed to help borrowers evaluate loans. Some to try include the mortgage calculators at https://www.bankrate.com and at https://www.financenter.com.

The calculators won’t guarantee you’ll make the right decision. They require you to guess how long you will own the house, and they don’t take into account the vagaries of people’s finances. A job loss or financial setback can make a once-affordable payment loom too large; conversely, a few raises or job promotions can make a bigger mortgage payment less daunting.

The calculators also don’t take into account human emotion, and how important certainty may be to your psyche. For many people, the peace of mind provided by a fixed payment for 30 years may be well worth the greater price.

Potential home buyer Joseph Onesta knows about the perils of unpredictable debt. He’s director of education at Consumer Credit Counseling Service of Los Angeles, a nonprofit organization that helps overextended borrowers renegotiate their debts. He’s also a graduate of the program, having once gotten in over his head with debt.

Onesta said ARMs are simply not an option for him, even though opting for a fixed rate means he would have to shave as much as $60,000 off the price of the home he could afford.

Years as a renter have made him long for stable payments, rather than an outlay that can soar or dive with little notice. “Some people are comfortable with that variability,” Onesta said. “I’m not. I’ve learned I want to be in control of my finances.”

Liz Pulliam Weston is a personal finance writer for The Times and a graduate of the personal financial planning certificate program at UC Irvine. Questions can be sent to her at liz.pulliam@latimes.com or mailed to her in care of Money Talk, Business Section, Los Angeles Times, Times Mirror Square, Los Angeles, CA 90053.

(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)

ARMed and Dangerous?

Here’s how loan payments could vary under different interest rate scenarios for someone who took an adjustable-rate mortgage tied to the one-year Treasury bill rate in April 1999 at a 5.87% teaser rate, versus someone who took out a 6.53% fixed-rate mortgage the same month. These payments are for a $200,000 loan with payments commencing June 1, 1999.

*--*

Payment Benchmark ARM ARM Fixed date T-bill rate rate payment payment June ’99 NA 5.87% $1,182 $1,268 June ’00 6.14% 7.87% $1,444 $1,268

*--*

Assumption 1: Interest rates stabilize

*--*

Payment Benchmark ARM ARM Fixed date T-bill rate rate payment payment June ’01 6.14% 8.89% $1,566 $1,268

*--*

Assumption 2: Interest rates rise over the next year

*--*

Payment Benchmark ARM ARM Fixed date T-bill rate rate payment payment June ’01 7.14% 9.87% $1,701 $1,268

*--*

Assumption 3: Interest rates fall over the next year