Is Your Adjustable Rate Mortgage Still The Right Choice?

Since June 2004, the Federal Reserve has steadily increased short-term interest rates from 1% to 3.5%, a “measured pace” according to Fed chairman Alan Greenspan. Yet mortgage interest rates have been holding onto record low levels.

What’s going on? What’s keeping mortgage rates low? Are low rates here to stay? And most important, how should homeowners and buyers choose the right loan in this environment?

Market Anomaly Creating Refi Options
First, let’s look at what’s going on in the markets. When you hear about the Fed raising or lowering rates, it’s in reference to the Federal Funds Rate. This is not a consumer rate. This is what the nation’s Federal Reserve banks charge each other on overnight lending to balance out their reserves each day.

But doesn’t movement in the Fed Funds Rate impact mortgage rates? Well, it should. The whole idea behind monetary policy is to set the tone for rate markets. But that’s not what’s happening. Shorter-term adjustable rate mortgages (ARMs) and longer-term fixed mortgage rates are not tied to the Fed Funds Rate but instead to mortgage backed bonds. These and other fixed income securities such as 10-year Treasuries are in high demand right now. They’re a safe bet when investors are uncertain about equities or about the impacts of high oil prices or a weak dollar.

All this demand has kept bond prices high. And bond prices and their yields (or rates) move inversely to each other. So when bond prices get bid up, their yields (or rates) drop—and mortgages follow suit.

The anomaly here is that there is now only a slim difference between the 10-year ARM and a 5-year ARM, creating a unique window of opportunity to move from a short to a long term loan option without a big rate bump.

How long will low rates last and the window of opportunity remain open? Nobody has a crystal ball, but the outlook is still strong for bonds—and for lower mortgage rates over the next one to two years. Many Wall Street economists point to the world’s aging population as further support for bond markets. These people, either individually or via pension and retirement plans, will likely switch from equities as an asset growth strategy to bonds as an asset preservation strategy.

The Right Loan Depends On Your Time Horizon
Now that you understand the factors influencing rates, it’s easier to choose the right loan.
The short answer is: You should choose your loan type and term according to how long you think you will be in the home.

If you’re buying your first home and are early in your career and/or newly married, you may be buying a home that you’ll outgrow as your income or family grows. So your objective is to estimate how long before you outgrow the home. Let’s say it’s five years. Then you’d want to finance the home with an ARM that’s fixed for five years.

The logic is that ARMs have lower rates than fixed rate mortgages—the shorter the ARM, the lower the rate. So why pay a rate on a 30-year fixed loan when you’ll only own the home for five? Better to take the lower five year ARM rate.

Taking this one step further, what if you’re the person who was on the five year plan described above? You’re two years into your 5-year ARM and your plans have changed. Now you’re going to keep your home for five more years. But your current ARM will start adjusting in three years.

Since you can’t predict markets and we’re in a record low rate environment that’s likely to be higher in three years, you go back to the basic premise: re-align your loan term to your predicted time in the home. It’s a luxury you have now that you might not have later.

Now, let’s take one more step. You’ve decided you’ll be in the home for five more years. You’re also thinking you want to keep the home as a rental property after that. Naturally, a new 5-year ARM is not the right choice. Again, you don’t want to run the risk of that ARM adjusting upward while you still own the property.

But you’ve looked at monthly payments on 30-year fixed loans, and they’re a bit too high for you. One thing you can do is split the difference. You can choose a 10-year ARM, which will still be fixed over the relatively long term and also have a lower rate and payment. But again, you have to come back to the basic premise: match your loan term to your expected time horizon.

Whatever your situation, it’s a good idea to call a Certified Mortgage Planning Specialist for further advice. The good news for you is that market events are creating an opportunity to rethink your mortgage strategy.