A farewell to ARMs

As short-term interest rates rise, adjustable-rate mortgages no longer are the home buyers' darlings. Fixed rates are making a comeback.
Aimee Blanchette, Star Tribune
January 21, 2006

When Jennifer and Rodolfo Trujillo bought their Wayzata home three years ago, their adjustable-rate mortgage seemed like a good deal. But with short-term interest rates rising, the Trujillos are among a growing number of people refinancing their adjustable-rate mortgages (ARMs), interest-only home loans or equity lines of credit into more stable financing.

In fact, in the latest weekly survey of mortgage applications from the Mortgage Bankers Association, applications for ARMs fell to 28.8 percent of all applications, down sharply from last year's peak of 36.6 percent reported in March.

Frank Nothaft, Freddie Mac's chief economist, forecasts that ARM lending activity will continue to slow throughout 2006. ARMs now account for about 30 percent of new loans. He expects ARMs to fall to around 25 percent by the end of the year as more homeowners switch to fixed-rate financing.

Rodolfo Trujillo said his loan adviser didn't correctly explain to him that the interest rates on his loans could rise as much as they did. Looking back, he realizes there probably were better products for his situation. "At least we're going to do the right thing now," he said.

The Trujillos had what's called an "80-20" interest-only mortgage that eliminated the need for mortgage insurance that would tack at least $100 onto their monthly payment. Eighty percent of the home's purchase price was financed with a primary mortgage. A line of credit financed the remaining 20 percent.

Typically, at least one of the loans, usually the smaller one, has an adjustable interest rate. The introductory rates on both the Trujillos' loans were fixed, but only for six months. Their loans started out with rates of 4.5 and 5.5 percent, but they've steadily increased to 6.75 percent and 7.85 percent, adding up to about $515 more in monthly payments. They knew it was time to do something different -- both for better financial stability and peace of mind.

"We think rates are going to skyrocket within the next few months, and we wanted the confidence of knowing what our payment would be," Trujillo said.

Worried that if rates climbed so high they'd be unable to refinance or sell their home in a slow housing market, the Trujillos enlisted the help of Cliff Morse, the branch manager at American Home Mortgage in Eden Prairie. They refinanced their mortgage last week and now have a 30-year fixed-rate loan at 5.75 percent, a rate they easily can afford. Their payment is only slightly higher than what they were paying just before refinancing, but the rate won't change and a portion of their payment will go toward the principal, thus paying toward their mortgage while building equity.

Morse said more than half of his customers have inquired about or have already taken steps toward refinancing to a fixed rate because ARMs no longer offer the advantage they once did for many borrowers. In fact, during the last week of 2005, short-term interest rates actually were higher than long-term rates.

With short-term rates at their highest since April 2001, and long-term rates at their lowest since last October, it now seems that fixed-rate mortgages are the better deal for many borrowers. Recently, for example, the average rate on a 30-year fixed-rate mortgage was 6.15 percent, while a 5-year adjustable-rate mortgage was 5.71 percent. For many borrowers the higher rate on the ARM doesn't offer the advantage it once did when the spread between short- and long-term rates was greater.

Most economists believe that the Federal Reserve will raise interest rates again at its next meeting. That means that loans tied to short-term rates including home equity lines of credit as well as ARMs will continue to move higher in 2006.

ARMs do have their benefits, however, and still are good options for many. Because home prices have grown so dramatically, ARMs are attractive options to get first-time home buyers in the door to start building equity. They're also good for people who know they'll sell their home or refinance before their rates are set to adjust upward.

Chris and Katie Rousemiller of Lakeville, for example, took action before the interest rate on their seven-year interest-only ARM was to reset in another four years. The interest rate on their home-equity credit line already had increased, adding $150 to their payment.

With the help of Chris' mother, Kris Wilson, a senior loan officer at Summit Mortgage in Bloomington, they're in a much better position.

"[Refinancing] saved their future," Wilson said. "The right time to do it was now, because long-term rates are still quite low relative to short-term rates. Historically, they are still low. And we don't know how long that's going to last."

The Rousemillers rolled most of their home-equity loan and their ARM into a single, 30-year fixed rate interest-only mortgage that lets them make more affordable interest-only payments for the first 15 years of the mortgage if they choose. They know it's prudent to start paying down the principal as soon as possible, but it's good to have the flexibility.

After refinancing, their combined mortgage and their remaining home-equity loan principal and interest payment will increase about $360. If they hadn't refinanced, their monthly payment could have doubled.

Morse said that although he doesn't foresee long-term rates going up all that much, many people are worried about it. His advice? "Refinance now with a fixed rate that's affordable to you, relax and forget about it."

A farewell to ARMs?