Mortgage Matters

April 19, 2006 9:13 PM

MoneyFilter: What should I do with my adjustable-rate mortgage?

Here's the vital info. I purchased a condo in 2002 for 190K with a 60K down payment. I started with a 30-yr mortgage of somewhere around 6.25%. In 2004, I refinanced under a 5-yr arm for 4.75% because I wanted to free up some cash flow.

News of rising interest rates has me feeling a little squirrelly. Did I do something completely stupid when I refinanced? Should I take action now or wait a few years and hope the economy doesn't take a nosedive? In case it matters, I have a very good credit rating and I plan on staying in my condo for the foreseeable future.

posted by wintermute2_0 to work & money (19 answers total)

I've heard from several sources (disclaimer: all involved in the purchase of our house) that variable rate mortgages are the lowest cost over any twenty years you care to choose from the history of this style of mortgage calculation.

I honestly have no idea if that is true. I queried back "Even during that nasty early nineties spike to 20-odd percent?" and was assured that, yes, even then.

I remain quite sceptical, and I look forward to someone with authority in the subject giving us an answer here.
posted by five fresh fish at 9:22 PM on April 19, 2006

I've got less-than perfect credit, and just got a loan at 6.75. Even using only reduced documentation. Depending on how badly overpriced your housing market is, rates are either gonna go up or way up. If you're planning on staying put, you could pay a couple points and get a lower rate on a fixed-rate. Your broker could probably tell you when the break-even point for each discount point purchase...yeah, get a fixed.
posted by notsnot at 9:38 PM on April 19, 2006

Whether fixed or variable, I would say the mistake you made was getting the ARM instead of a normal mortgage. Arms are typically reserved for people who are buying property to rent it out or for those who plan to flip it after a couple of years. In your case, I think not building equity is a huge mistake and the extra cash flow it gave you is probably being at least somewhat wasted.
posted by SeizeTheDay at 9:43 PM on April 19, 2006

This page appears to have the historical index data for Constant Maturity Treasury - I believe the one year CMT is the base rate for most ARMs with annual resets.

I'm in no position to predict interest rates, but I'll share a few observations. I was surprised to learn than many of the people I work with, and these are people who work in the capital markets everyday, have 5/1 ARMs that were taken out in last 18 months.

I need to check on the Bloomberg terminal at the office tomorrow, but I believe the forward treasuries curve is only slightly higher for short-terms than it is now. That is, the interest rate futures market is expecting short-terms rates to be slightly higher in 3 or 4 years than they are now (but long-term rates move up more dramatically as we are expected to move back to a steep yield curve from the current flattening curve). If you put any credence in the wisdom of the futures market, this would be comforting to you. Of course, someone please correct me if I'm mistaken - I will be sure to check in the morning.
posted by mullacc at 9:50 PM on April 19, 2006

I personally moved from a 5/1 arm two years ago to a 30 year fixed because rates are, historically speaking at an incredible low and I knew I want to keep my place for a long time. My rule of thumb is watch the fed, watch yield curve, look at the time left on an 5/1 (I refi'd through two 5/1's before the 30 yr. fixed), and look at the ceiling on my rate (that was the kicker for me because I knew I would go into a forced sale if I had to pay 11 percent on my jumbo).

The nice thing is this kind of concerns wakes you to macroeconomic indicators. Inflation has had an unexpected gain this month, my view is elevated crude prices are adding inflation. Are productivity gains masking some of it? Maybe.

In any case, if I were you I would get out. There are far far too many people in 5/1s and the profile is very scary when you look at how many folks will need to get out over the next couple years. Another thing to ponder (and puzzle) is all those negative amortization loans. Go figure. That, in my mind is adding considerable instability to the market.
posted by zia at 11:31 PM on April 19, 2006

SiezeTheDay wrote: Whether fixed or variable, I would say the mistake you made was getting the ARM instead of a normal mortgage.

wintermute2_0 has a variable rate mortgage, also known as an adjustable rate mortgage or ARM. Perhaps you're thinking of an interest-only mortgage?

BTW, interest-only mortgages are not necessarily any more dangerous than traditional ARMs. Never paying any principal—now that's dangerous. But the having the option isn't.
posted by ryanrs at 1:56 AM on April 20, 2006

I agree with whoever posted that variable rate loans have been cheaper than fixed ever since the bad old days of 20% - however, variable rates weren't widely used before that time, and since then, rates have mostly only moved downward. If you believe the economy is sound and that the price of oil will stabilize, maybe you can ride it out. If you don't (I don't), now isn't a bad time to bail. We're not at historical lows, but the rates are still very good.
posted by clarkstonian at 4:42 AM on April 20, 2006

From Calculated Risk, the average rate for 30-year fixed is 6.56%, compared to 6.00% for an ARM. If the difference is that small in the long run, once your ARM adjusts, I'd say the fixed rate is probably a better deal. Interest rates are a lot closer to the lowest they can go than they are to the highest they might. If you don't want to take the chance of being forced to sell, the time to switch to a fixed-rate mortgage is before you can no longer afford to do so. But of course it depends on your tolerance for that risk.
posted by sfenders at 5:16 AM on April 20, 2006

Perhaps you're thinking of an interest-only mortgage?

You are correct. My fault. Please ignore my comment completely. Sorry all.
posted by SeizeTheDay at 5:22 AM on April 20, 2006

I can't find it, but there was an article in the Wash Post just yesterday that said only one more 1/4 pt rate hike is likely for awhile assuming inflation/home prices/etc stay in check.

In any case, I'm not sure anyone here can tell you what the right thing to do is, since none of us can see into the future.
posted by poppo at 5:49 AM on April 20, 2006

The way I've seen the decision described elsewhere is that the real question is "what is your peace of mind worth to you?". If you are on the edge of affordability and would be wiped out by an increase in rates then a fix is the way to go. The key is that you shouldn't look back and say you made the wrong decision just because you could have paid less by taking a variable rate - the decision now is about the value to you of knowing your payments each month.
posted by patricio at 6:29 AM on April 20, 2006

What is the interest rate cap on your ARM? How much would your monthly payments be if your interest rate went that high? If that high-end number freaks you out and you can afford a fixed-rate mortgage, go get one.

I see this as a matter of managing risk. You can gamble that interest rates won't go up much more, or you can take the sure bet which costs a little bit more today. Given how fundamental housing is, both for basic security and for long-term financial security, I would go for the sure bet.

Note that if interest rates go down, you can always refinance at a lower rate. But if they go up and you are in an ARM, you are screwed.

As for the likelihood of a significant increases in interest rates, the short-term thinkers don't see them, but people who watch the overall macroeconomic condition of the U.S. (e.g. the current account deficit) pretty much think they are inevitable. It's only a matter of when.

Sorry, no links. No time this morning.

Good luck with your decision!
posted by alms at 6:55 AM on April 20, 2006

Your ARM likely has limits on how quickly the rate may increase once it starts adjusting. The language likely allows the rate to increase by a maximum of 200 basis points (2 percentage points) at any single adjustment and by no more than 600 basis points (6 percentage points) over the the initial rate. Your language may differ but the above is very common. In any case, it is quite simple to run a breakeven to your maximum exposure to interest rate moves.

Create four columns on a spreadsheet...in the first column input the monthly payments of your proposed fixed rate mortgage for the next ten years...in column two create a running cumulative total of column one. In the third column, input your current monthly payment for the months until your first scheduled reset...then input the next twelve payments assuming the rate increases by whatever your one time maximum increase is (2 points in my example above) and increase it annually by that maximum until you reach the lifetime maximum increase. (6 points in my example) In column four, create a running cumulative total of column three. Comparing columns two and four will give you a worst case for how long you have until the two strategies are breakeven. I ran it just now using a 6.5% new mortgage and my assumptions on maximum increases and the breakeven works out to about 68 months. If you think you are likely to have a better opportunity to refinance over the next five and a half years you should stay with your current mortgage...if not, you should refi now. It is important to keep the monthly cash flow consequences in mind also...if you stick with your current mortgage and it hits the maximums, your monthly payment will be 80% higher in year five than it is now.

Remember that this calculation is a worst case...there are few economists who would argue that long term rates are likely to increase enough over the next three to five years to push your mortgage to those maximums...but there are a lot of reasons to question that logic given the current global environment and the potential impact of oil instability on global rates.

You mentioned your fear about the economy taking a nosedive...if you plan to stay in the house, that would be good for your ARM...a weaker economy typically causes rates to fall.

If you will sleep better with a locked-in long term rate, go for it...just make sure you understand the opportunity cost.
posted by cyclopz at 7:02 AM on April 20, 2006

I am in the middle of buying a house- just got the mortgage committment and now I just have to wait to move.

cyclopz has a great method- I did a similar thing to compare, over a seven-year period, how much it would cost me vs. how much equity I would be building with a 7yr ARM, a 7yr interest-only ARM (paying $200 extra every month), and a traditional 30yr fixed. For me, the 30yr fixed was by far the best choice- I am paying one point for a 5.5% interest rate!

Bottom line is, you just have to crunch the numbers. What looks good at first glance isn't always what's best.

But if I were you, I'd consider moving as an option. I'm sure you've built a ton of equity in your condo (over and above your down payment), AND it's appreciated in value.
posted by elisabeth r at 7:25 AM on April 20, 2006

Crap, you people are paying high rates. My floating-rate mortgage is at prime - 0.75%, which means it currently stands at under 5%. A year ago or so, it was under 4%.

My father has had mortgages at under 3%. Mind, he had a swack of security to back that up.
posted by five fresh fish at 9:55 AM on April 20, 2006

I don't know much about the mortgage business, but this site might help you plan stuff out yourself... Mortgage Calculator Site

It's a pretty comprehensive list of calculators, and you could probably throw out a few different options for youself and figure out what the costs/payments would be to you.

good luck...
posted by TheDude at 10:08 AM on April 20, 2006

Ummm...FFF you might want to check your rates...Prime rate is currently 7.75% which means your mortgage is 7%.
posted by cyclopz at 12:16 PM on April 20, 2006

Prime is 5.5%
posted by five fresh fish at 1:56 PM on April 20, 2006

Well I guess I could have checked your location...prime in the US is 7.75%.
posted by cyclopz at 2:12 PM on April 20, 2006