A Call to ARMs

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It's never easy to understand exactly what Alan Greenspan means when he makes his periodic Delphic statements about the financial system. But the Federal Reserve chairman set a new whazzat? standard recently when he suggested that the millions of homeowners who proudly hold a fixed-rate mortgage — roughly 80% of all those with a mortgage — are committing a financial blun-der that may cost them thousands of dollars a year.

Huh? Interest rates across the board are near 45-year lows. How could it be a mistake to lock in a low rate now and know your monthly principal and interest payment will never rise?

In Greenspan's view, this peace of mind simply comes at too high a price. Look at today's mortgage rates: the average 30-year fixed rate is 5.7% vs. just 3.7% for the average one-year adjustable-rate mortgage, or ARM, which resets every year. On a $200,000 loan, the fixed rate costs $1,160 a month, while the ARM costs just $921 a month for the first year. What happens after that is where it gets interesting. Within two years the ARM could rise as much as 4 percentage points, bringing the monthly payment to $1,407. Most homeowners don't want to worry about that, so they lock in the fixed rate.

In opting for that higher rate, though, homeowners win only if rates rise. If rates remain stable or fall, the ARM is by far the better deal because the rate starts out low and automatically adjusts downward without the cost of refinancing. Beyond that, Greenspan said, fixed-rate borrowers pay an excessive premium. In high finance there is a quantifiable cost to fix a rate for 30 years. Home-owners pay about 1 percentage point on their loan rate for it, while mortgage lenders (which must hedge their rate risk) pay less than half of that. Over the past 10 years, homeowners with a fixed-rate mortgage "might have saved tens of thousands of dollars had they held adjustable-rate mortgages" instead, Greenspan said.

For example, a homeowner who borrowed $200,000 in January 1993 at a 30-year fixed rate and refinanced every time rates fell 1.5 percentage points would have paid a total of $110,000 in interest and refi costs the following seven years. An ARM borrower would have paid just $100,000 over the same period. The ARM borrower did better in 87% of the rolling seven-year periods since 1989, an era of declining rates.

Should you be in an ARM? In a time of rising rates, ARMs lose their advantage. That's no small caveat. Rates have been declining for most of the past 20 years, a cycle that has probably ended. Yet few economists expect rates to shoot higher and keep moving up. If rates rise 2 percentage points over several years, an ARM might still prove cost effective. Underlying the Fed chief's call to ARMs is that we could be in a low-rate environment for years.

You're not a good ARM candidate if you live on a fixed income, and anyone planning to stay put for 10 or more years should lock in a fixed rate now. But the average homeowner sells after just seven years and thus would be better off in the right ARM.

Greenspan challenged the mortgage industry to offer new products that bring down the cost of peace of mind. Most buyers couldn't care less how much of their monthly payment represents interest; they just want to know the payment won't change. One way to fix the payment without the cost of fixing the rate is to hold an adjustable-maturity mortgage — in which the payoff period, not the monthly outlay, rises and falls with interest rates. Outside the U.S., fixed-rate deals are far less common, and adjustable-maturity mortgages are readily available. An ARM with a lifetime rate adjustment of just 2 percentage points (as opposed to the standard 6) also addresses this issue.

At least homeowners who have a good idea of how long they'll stay put have options right now. So-called hybrids — for which the rate is fixed for three, five, seven or 10 years and then reset annually — make a lot of sense, allowing you to shave up to 1.5 points off the 30-year fixed rate.