- The Washington Times - Wednesday, May 17, 2006

Last week, I wrote about a radio segment that told the sorry tale of homeowners who hold adjustable rate mortgages (ARMs).

ARM holders are now facing ugly rate and payment increases as their mortgages are being reset. It seems that thousands of ARM holders across the country didn’t become aware of the steady rise in rates, despite the consistent warnings by the Federal Reserve Board.

My guess is that there are plenty of ARM holders who chose to ignore these warnings and hold their ARMs because most adjustables were still well below 5 percent when the Fed began its series of rate hikes.

Even though fixed rates were below 6 percent at the time, ARM holders found it difficult to refinance a low ARM rate, despite every indication that they would soon be a lot higher.

But that’s water under the bridge. Today, ARM holders are facing new rates in the 7 percent range and clearly feel as though they’ve missed the boat. While these folks may not have timed the mortgage market perfectly, the boat is still at port.

Although short-term rates have shot up considerably, long-term rates have increased at a much slower pace, keeping the door open for ARM holders to convert to a fixed rate that, by historical standards, is still pretty good.

The fact is that most ARMs are adjusting to rates higher than today’s fixed rates. Let’s take a look at some common ARM indices.

• ARMS tied to the LIBOR, or London Interbank Offering Rate were very much in favor from 2001 through 2004. The LIBOR tends to follow U.S. short-term rates and often will move more dramatically. This is why LIBOR-based ARMs were so popular. When the Fed was lowering rates, the LIBOR followed with enthusiasm, dropping more than most other ARM indices. Unfortunately, the LIBOR behaves in the same manner when it’s on the rise — moving higher than most other indices.

• The one-year Treasury Constant Maturity (TCM) is based on Treasury bills auctioned off by the federal government. This is a less-used index for ARMs but can be expected to move similarly to other short-term interest rates.

• The 12-Month Treasury Average (MTA) averages the yields on Treasury bills over a period of one year, making it slower moving and less volatile.

Now let’s look at the actual rates of theses indices:

• The yield on the monthly LIBOR is hovering at just over 5 percent. Most LIBOR-based ARMs carry a margin between 1.75 and 2.25 percent. The margin is the amount added to the index to determine the actual interest rate on the mortgage.

Adding a 2 percent margin to a 5 percent index means that the new LIBOR-based ARM is now at a “fully indexed” rate higher than 7 percent.

m The one-year TCM is currently yielding just below 5 percent. Most ARMs with a TCM index carry a margin of at least 2.50 percent, making the fully indexed rate close to 7.50 percent.

• The slow-moving and lagging MTA is currently hovering around 4.125 percent. A common margin of 2 percent would put these ARM holders at 6.125 percent.

What’s an ARM holder to do?

My strong advice would be to refinance to a fixed rate and pay small or no fees. Currently, 30-year fixed-rate loans with little or no closing costs can be found at around 6.50 or 6.75 percent. Since most ARMs are adjusting to higher rates, keeping an ARM makes no sense.

For those folks whose ARMs have not yet adjusted and are still paying a low rate, my advice is the same: Forgo the low teaser rate if your ARM is due to be reset in the next 12 to 24 months.

I tell borrowers to accept a slightly higher rate in lieu of high up-front costs and points.

Interest rates are dynamic, and although they are predicted to continue to rise a bit more in 2006, there’s no certainty they will stay up.

If the economy slows, there’s a good chance rates could drop in 2007 or 2008.

Don’t be fooled by low rate/high cost mortgage programs. Keep your closing costs down.

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

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