- The Washington Times - Thursday, March 3, 2005

Q: I have a $360,000 LIBOR-based adjustable-rate mortgage. The rate fell as low as 3 percent but has jumped in recent months to 4.50 percent.I know that you have written about these LIBOR ARMs in the past, and I am wondering if you still think they’re the great deal that they once were.

A: Your question provides a great opportunity to revisit LIBOR ARMs and explain another product that is surely more attractive in this dynamic environment.

But first let me start with a quick recap of what LIBOR ARMs are. LIBOR stands for London interbank offering rate. Basically, this is the interest rate European banks charge each other for short-term loans.

The LIBOR is market-driven, but it tends to follow U.S. short-term rates, which are governed by the Federal Reserve Board. As most of us know, the Fed engaged in an aggressive campaign to ease credit by lowering rates after the September 11 attacks. It was shortly afterward when LIBOR-based mortgages piqued my interest.

Indeed, I began writing about the LIBOR ARM back in January 2002, when the fully indexed rate was near 4 percent.

In response to the falling U.S. rates, the LIBOR was sliding lower and lower. A 4 percent mortgage was a great deal back then, and the LIBOR mortgage eventually fell to less than 3 percent. For those homeowners who took out LIBOR ARMs, it’s been a great ride.

Now that Fed Chairman Alan Greenspan has made it clear he intends to continue to nudge up interest rates at a “measured” pace, the LIBOR index is following right along.

Homeowners who enjoyed watching their LIBOR-based mortgage rate drop to 3 percent last June are now looking at rates in the 4.5 percent range.

Still, 4.50 percent isn’t bad, but a 1.5-percentage-point increase is a big jump.

Let me now answeryour question.

Yes, 4.50 percent is a good rate in comparison to many other mortgage programs, but no, it’s obviously not as good a deal as it used to be.

The important thing to understand about mortgages is that some programs are clearly better than others, based solely on market conditions at the time.

I want to quickly talk about yet another program, called the MTA ARM, or monthly Treasury average ARM.

We can safely say that the LIBOR is likely to continue to rise as long as the Fed keeps its promise to continue to raise rates. In fact, we can be safe to suggest that all ARMs that are tied to short-term rates are likely to continue to rise.

Does this mean everyone should abandon ARMs and go with a fixed rate? Definitely not.

Fixed-rate percentages are hovering in the high 5s to low 6s, while some monthly ARMs are still in the mid-4-percent range.

For folks who are looking to hold the property for only a couple of years or perhaps are trying to improve cash flow, an ARM still makes plenty of sense. It’s just that the LIBOR is not as attractive as the MTA.

The name “monthly Treasury average” says it all.

Let me explain. Adjustable-rate mortgages have two components: index and margin. The index is some financial instrument that determines the movement of the mortgage rate. The margin is the fixed amount that is added to the index to determine the actual interest rate on the mortgage.

For example, the one-month LIBOR is an index, and the margin might be 2.50 percent. The monthly LIBOR is currently hovering at around 2.60 percent.

Add a margin of 2.50 percent to get a fully indexed rate of 5.10 percent.

Whatever the LIBOR rate is at the time of adjustment, the new mortgage rate will be 2.50 percent higher. This makes for a potentially volatile mortgage plan.

The MTA is an index based on the average rate of the one-year Treasury bill over the preceding 12 months. Because the index is based on the average rate, its movement is much slower.

For example, the yield on the one-year Treasury bill might jump from 2 percent to 2.5 percent in one month. A mortgage program tied directly to the one-year T-bill would increase by 0.5 percent in one month.

But the MTA takes the average yield over 12 months. On the first day of each month, it updates the average by dropping the oldest yield and adding the newest. In periods of rising interest rates, the MTA will certainly increase, but it will increase only gradually.

The bottom line is this: If you are inclined to take a monthly ARM for whatever reason, an ARM that’s based on an annual average is favorable in a rising-interest-rate environment.

Alternatively, if the Fed begins a campaign to drop rates, an ARM tied to an annual average will drop very slowly.

Henry Savage is president of PMC Mortgage in Alexandria. Reach him by e-mail ([email protected]pmcmortgage.com).

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