Adjustable Loans May Still Be the Right Choice

Mortgage rates have been ticking up since March, and the trend is expected to continue if the Federal Reserve raises interest rates next week, as is widely expected.

Conventional wisdom says this is the time to lock in low rates with a 30-year fixed-rate mortgage. But conventional wisdom may be wrong -- an adjustable-rate mortgage, or ARM, may still save some borrowers thousands of dollars.

Some lenders have a strong incentive to push these adjustable loans, because they shield the companies against losses if interest rates take off. Moreover, at a time when some borrowers are getting priced out of the fixed-rate loan market, the low start rates on adjustable mortgages can keep business coming in the door.

Those incentives mean there are some good deals for borrowers, especially those who plan to sell or refinance a home within six to eight years.

The reason is simple: Start rates on many ARM loans are significantly lower than the current rates on fixed-rate mortgages. And contractual limitations on how quickly the interest rates on an ARM can adjust virtually guarantee that many borrowers will enjoy lower interest rates for years.

Moreover, if interest rates rise relatively slowly -- as some experts believe they may -- the benefits of adjustable loans can prove even greater.

“I think interest rates will be higher in a year, but I don’t think there is a danger of runaway rates,” said Steve Foster, president of Vista Financial, a mortgage brokerage firm in North Hollywood. “Meanwhile, there’s a lot of room to run with these adjustables, which allows you to save money.”

ARMs are far more complicated than fixed-rate loans, though, so borrowers must pay close attention to the details, Foster said. On the bright side, the industry offers such a wide variety that savvy borrowers can match their needs to a loan that provides both monthly savings and some security.

Those who can handle risk, for example, could take out a one-month adjustable with an introductory rate as low as 1.25%, Foster said. That’s right -- a one-month adjustable, meaning the low rate is good for only one month. But if interest rates don’t rise more than 2 percentage points over the next few years, this loan will remain considerably cheaper than fixed-rate loans, Foster said, which may make it sensible for homeowners who plan to sell in relatively short periods.

The loan has a maximum interest rate of 9.5%.

Foster notes that borrowers who don’t want to bear an immediate risk of rising rates can choose “hybrid” adjustables, which offer fixed rates for the first three to 10 years.

The so-called 7-1 hybrid ARM, for example, locks in an interest rate for seven years. The current rate is 5.8%, compared with the going rate on a 30-year fixed-rate loan of 6.4%, said Keith Gumbinger, vice president of HSH Associates, a Butler, N.J., rate-tracking firm.

For a $300,000 loan, the monthly payment with the 7-1 loan would be $1,760.26, compared with $1,876.52 for a 30-year fixed loan. That savings of $116.26 a month would amount to $9,766 in the first seven years.

If interest rates dive again during the fixed-interest period, allowing the homeowner to refinance, that savings is permanent. (That also holds true if the homeowner sells.) Otherwise, the borrower faces the prospect of higher rates when the seven years are up.

How much higher? It’s impossible to predict interest rates, of course, but borrowers can figure out a worst-case scenario for an adjustable-rate loan because of so-called caps, Gumbinger said. The typical adjustable loan will have at least one restriction, and possibly several, on how high the interest rate -- or payment -- can go in any given year and during the life of the loan.

With many ARMs, including these hybrids, the caps typically restrict the interest rate from rising more than 2 percentage points in a year or by more than 6 percentage points during the life of the loan.

Translation: The worst that could happen to the borrower on this 7-1 ARM would be that the interest rate would be 7.8% at the first adjustment period. That would boost the monthly payment to $2,159 -- about $283 a month more than it would have been with the fixed-rate loan.

An increase of 6 percentage points, meanwhile, could boost payments to $3,039.73. But the loan could not hit those levels until the 10th year based on the rate caps in the contract.

How long would it take for the higher monthly payments to eat up the savings the borrower enjoyed during the first seven years of the loan? At 7.8%, it would take almost three more years.

If interest rates continued to rise, this borrower could face a second rate increase at the beginning of the loan’s ninth year, to as much as 9.8%. However, the lifetime cap on the loan would stop the rate from going higher than 11.8% no matter how high interest rates rise.

In any event, for the first eight to 10 years, this borrower is ahead for having chosen the adjustable. And it’s worth noting that the typical loan is paid off, as the result of a sale or refinancing, within six to eight years, Foster said.

“Most borrowers leave money on the table by going for the 30-year fixed-rate product when they could have had much lower rates for the period that they had the loan by using an adjustable,” said S.A. Ibrahim, a director of the California Mortgage Bankers Assn. in Sacramento and chief executive of Greenpoint Mortgage in Marin County. “Even in a rising-rate environment, you can benefit from an ARM.”

That said, borrowers who are risk-averse, who expect to stay in their home for decades and who don’t expect to refinance in the next 10 years are probably better off with a fixed-rate loan, Ibrahim said. Even though rates on fixed-rate mortgages have risen in the last several months, they remain at historically low levels.

But those who can handle a bit of uncertainty may find the adjustables worth a close look, said Brian Regan, chief consumer officer at Lending Tree, a rate-shopping website. Still, consumers should shop carefully, and make apples-to-apples comparisons between loan rates and terms, he said.

“There are so many flavors of ARMs now,” Ibrahim said. “If you do your homework properly, ARMs can make sense. But you have to be very careful.”

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Kathy M. Kristof welcomes your comments and suggestions but regrets that she cannot respond individually to letters or phone calls. Write to Personal Finance, Business Section, Los Angeles Times, 202 W. 1st St., Los Angeles, CA 90012, or e-mail kathy.kristof@latimes.com.

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Pay Attention to Terms of Adjustables

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In times of rising rates, it’s smart for borrowers who have adjustable-rate mortgages to look at worst-case scenarios to figure just how high their interest rates or payments can go.

How do you do that? Experts suggest that you look at four things in the loan agreement: the index, the margin, the adjustment periods and the “caps.”

Index: The most common indexes are the cost of funds index, a slow-moving measure of what Western banks are paying for consumer deposits; the London Interbank Offered Rate, or Libor, which reflects what banks charge one another for short-term borrowing; and the constant-maturity Treasury index. At the moment, all of these indexes are in the 1.5%-to-2.5% range. Bankers can provide long histories -- usually several decades of information -- about how these indexes have reacted to interest rate swings over time.

Margin: To determine the “fully phased-in” rate on an adjustable loan, you add the index to a margin -- usually 1.4 to 2.4 percentage points. That margin reflects the bank’s profit and administrative costs on the loan. A borrower with a 2-percentage-point margin on a so-called COFI loan would add 2 percentage points to the current COFI rate of 1.802 to get a current interest rate of 3.802%.

Adjustment periods: The interest rate remains settled until the adjustment period. When that adjustment will occur depends on the type of ARM. Monthly adjustables can change once a month, but there are also loans that adjust once every three months, once every six months and once a year. Hybrid adjustables offer a longer fixed-rate period -- three to 10 years at the start of the loan -- and then adjust once annually after that.

Caps: Most contracts also insulate borrowers from rapidly rising interest rates by setting caps on either payments or interest rates.

Short-term ARMs, such as monthly adjustables, typically offer a payment cap of 7.5% a year, said Steve Foster, president of Vista Financial in North Hollywood. In other words, if the required monthly payment was $100, it couldn’t go higher than $107.50 the following year.

It is important to note that payment caps aren’t tied to interest rates, and in some cases the borrower could end up with something called “negative amortization.”

In the above example, that means that if rates rose enough to push the required monthly payment to $120, but your payment cap limited the payment to $107.50, the $12.50 monthly difference would be added to the balance of the loan. The borrower would end up owing more at the end of the year than at the start, unless he or she made bigger payments than the cap required.

One-year and hybrid adjustables generally offer annual interest rate caps, which promise to limit rate increases to no more than 2 percentage points a year.

In addition, nearly all adjustable loans have lifetime interest rate caps that set a maximum, no matter how high rates go. Currently, one-month adjustable loans usually promise that the loan rate will never exceed about 9% or 9.5%, Foster said. Other adjustable loans may restrict rate increases to no more than 5 or 6 percentage points over the start rate.

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Mortgage loan calculator

Homeowners with adjustable rate mortgages can calculate how much their monthly house payments will be at different interest rates, using the chart below. For example, if you have a $247,000 adjustable loan and you expect the rate to rise to 6%, multiply $247,000 by 5.995. The answer is $1,480.76, which is what your monthly payment would be at 6%.

*--* Rate Multiplier 2% 3.696% 2.5% 3.951% 3% 4.216% 4% 4.774% 4.5% 5.067% 5% 5.368% 5.5% 5.678% 6% 5.995% 6.5% 6.321% 7% 6.653% 7.5% 6.992% 8% 7.338% 8.5% 7.689% 9% 8.046% 9.5% 8.408% 10% 8.776%

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Note: All these multipliers assume 30-year amortization periods.

Source: Times research