By Jeff Brown
With remarkably low rates, most home buyers shopping for mortgages this spring should probably pick the old-fashioned 30-year fixed-rate loan, which average 4.98 percent, according to the BankingMyWay.com survey.
One-year adjustable-rate mortgages (ARMs), with a first-year rate averaging 5.25 percent, don’t offer any up-front savings to offset the risk of rates going higher in the future. To be attractive, ARMs generally have to start at 2 percentage points below the 30-year fixed rate.
But decisions are trickier for people who already have ARMs. In the long run, it might pay to refinance to a cheap fixed-rate loan, assuring you won’t pay a higher ARM rate later. However, because interest rates have fallen so steeply, many older ARMs have adjusted to rock-bottom rates, often less than 4 percent, so homeowners should think twice before giving them up.
A key factor is the “index” used in the interest-rate resets, which typically come every 12 months. Adjustments are done by adding a set number of percentage points to the index value on the reset date.
One of the most common indexes is the One-year Constant Maturity Treasury. This is the interest rate paid by a form of U.S. Treasury bond with one year left before it matures, which is when investors get their principal back.
Currently, one-year Treasuries are yielding a scant 0.59 percent. An ARM with a 2.75 percent margin that reset today would therefore charge just 3.34 percent for the next 12 months.
Other indexes aren’t as low. The six-month LIBOR rate, which tracks certain bank loans, is at 1.827 percent. With a 2.75 percent margin, a loan using this index would adjust to 4.58 percent.
The Three-year Constant Maturity Treasury is at 1.28 percent, the Five-year Constant Maturity Treasury is 1.76 percent, and the 11th District Cost of Funds Index is 2 percent. A number of online services consolidate this data, and there's a great tool available to you at BankingMyWay.com.
You might consider sticking with an ARM that tracked the one-year Treasury, because it offers a fairly sizeable savings over the current 30-year fixed rate. But there’s less saving with a loan tracking LIBOR, so it might be a good time to switch to a fixed rate. Use the BankingMyWay.com mortgage tool to search fixed-rate loans. Many lenders, such as Wachovia, a unit of Bank of America (Stock Quote: BAC), offer fixed-rate deals that beat the national average.
Keep in mind that ARM indexes change constantly. The one-year Treasury rate was at 3 percent as recently as January 2008. If it rose to that level again, a loan with a 2.75 percent margin would adjust to 5.75 percent. That’s not bad by historical standards, but if rates rise in the future, you might kick yourself for passing up the chance to lock in the current fixed rate below 5 percent.
Use the BankingMyWay.com calculator to determine your ARM payments at various interest rates.
Also consider the “caps” in your ARM, or limits on how much the interest rate can rise or fall in an adjustment. Many limit annual moves to 2 percentage points, and don’t allow the rate to ever rise more than 6 points above the starting rate.
Another factor is how long you expect to have the mortgage. If you expect to sell your home in just a few years, a rate increase from a future reset could not hurt you for very long. It might be worth risking, especially considering the thousands of dollars you might pay to refinance.
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