- The Washington Times - Thursday, February 15, 2007

Q:I was looking into refinancing my $400,000 mortgage because my adjustable rate is about to change.

I don’t plan on being in the property for more than two years, so I thought I should take out another ARM. The lenders that I spoke with told me that adjustable rate loans carried higher rates than fixed-rate mortgages. I always thought the adjustables were lower because the borrower absorbs the risk of a higher rate in the future.

Are these lenders trying to sell me a fixed-rate mortgage because they can make more money?

A: No. The lenders you spoke with are correct. Most adjustable rate mortgages are currently carrying an initial fixed rate that is higher than 30-year fixed-rate loans.

You are also exactly correct that it doesn’t make sense. The lenders you spoke with should have explained this interesting phenomenon. It’s called an “inverted yield curve,” and it’s been inverted for more than a year.

ARMs should carry a lower rate because the interest-rate risk is put upon the borrower rather than the lender. If, for example, a lender offers a 30-year fixed-rate mortgage at 6 percent, it is stuck with receiving 6 percent annual interest for the life of the loan. If, a year later, interest rates rise to 7 percent, the lender has its money tied up in an investment that is earning 1 percent under what it could otherwise earn. The borrower is obviously unlikely to refinance.

If the loan carried a feature that allowed the rate to adjust annually, the lender would be able to receive a higher market rate. The borrower is subject to paying the higher rate.

An inverted yield curve means that short-term loan instruments are yielding a higher rate than long-term fixed loans. Logically, it may not appear to make sense, but there is an explanation.

Most short-term interest rates are directly affected by the Federal Reserve and its policies. The Fed has the power to control an interest rate called the Federal Funds Rate, which is simply the rate that banks charge each other for overnight funds. When the Fed decides to change this rate, other short term rates, such as ARMs, will be affected.

Long-term rates, such as 30-year fixed-rate mortgages, are governed by market forces. These loans are packaged and sold as mortgage-backed securities to individual and institutional investors. Since fixed yield instruments are not a good investment during an inflationary period, investors shy away from them, lowering the price but increasing the yield.

An inverted yield curve tells us that the Federal Reserve and the market disagree with each other. They are butting heads. The Fed has raised short-term rates many times over the last couple of years to prevent the economy from overheating and causing inflation. If the market agreed with the Fed that these rate increases are warranted, long-term rates would also rise because the demand for fixed rate mortgage backed securities would fall, ultimately raising interest rates.

But the market demand for mortgage-backed securities has remained strong, which is keeping the rates on 30-year mortgages down. It appears that the market is not as concerned about inflation as the Fed.

So go ahead and take that 30-year mortgage until the market and Federal Reserve Board sort things out. But keep in mind my mantra: Since you plan on holding the loan for only a short period, avoid paying points and closing costs if you refinance.

Henry Savage is president of PMC Mortgage in Alexandria. Reach him by e-mail (henrysavage@ pmcmortgage.com).

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