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Spencer for Hire :: Here Come the Adjustables

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Adjustable-rate mortgages are making a comeback in response to a steep rise in the cost of fixed-rate loans. But industry experts worry that borrowers who have enjoyed a long period of declining interest rates may be unaware of how risky ARMs can be in a rising rate environment.

The appeal of adjustable loans is that their initial interest rates, and monthly payments, are significantly lower than those of fixed-rate loans. Where the average rate for a 30-year fixed loan was 6.25 percent last week, the average rate for an adjustable loan was 3.80 percent, according to the Mortgage Bankers Association.

No wonder more homebuyers are turning to adjustables, considering the surge in fixed-rate loan costs from less than 5 percent in mid-June. The pace of consumers choosing adjustables picked up in July, and in August they accounted for more than one-fifth of mortgages every week.

In other periods of rising rates, such as in 1999, ARM loans have accounted for more than 40 percent of all loans.The catch today is that the lower rates on ARM loans probably are temporary.

From mid-2000 to mid-June of this year, ARM borrowers benefited from a steady decline in interest rates. But if the economy continues to recover, current borrowers face the strong possibility that market rates will rise further, pushing their payments higher as soon as the loans' first adjustment date. What's more, because of the way some ARM loans are structured, their rates could rise even if market rates stabilize near current levels, experts warn.

How soon rate adjustments could occur, and how high ARM loan rates could go, would depend on the type of loan and on market interest rate trends. Borrowers need to carefully consider a few key elements of an ARM to make sure that they can handle the risks:

• Adjustment periods. The day of reckoning with an ARM generally is the first adjustment date. That's when the rate on the loan can move from the initial offered rate to either the "fully indexed" rate or the "rate cap," whichever is less. (More on indexes and rate caps later.)

How quickly this day comes can vary widely. Some adjustable loans offer only one month's respite from interest rate hikes, whereas so-called hybrid adjustables can offer up to 10 years of a fixed rate before the first adjustment. After that first adjustment, hybrid loans usually adjust their rates once a year.

In times of declining market interest rates, the best ARM loan deals are those that adjust frequently, such as the monthly adjustables.

In today's rising-rate environment, however, more home buyers are likely to favor ARMs that offer a fixed rate for years rather than months. But such ARMs also are more costly. Countrywide, for example, was recently charging 3.25 percent on ARMs that adjust once a year, while its rate was 5.5 percent for loans that offered a five-year, fixed-rate period before adjusting.

• Index and "margin." The fully phased-in interest rate on an ARM is calculated by adding a "margin"--a set number of percentage points--to an index. The most commonly used ARM indexes are the London InterBank Offered Rate, or LIBOR (a measure of banks' short-term funding costs), and the one-year U.S. Treasury bill interest rate.

The benefit of the T-bill index is that it's somewhat less volatile than the LIBOR rate. But as a result, most banks charge a bigger margin on T-bill-based loans. Typically, adjustables will be priced at the LIBOR rate plus 2.25 percent or the T-bill rate plus 2.75 percent, he said.

Because the indexes are short-term interest rates, their moves depend in large part on the Federal Reserve, which controls such rates in the U.S.

For now, the Fed is pledging to keep short-term rates at current 45-year lows, which is a help to ARM borrowers. But if the economy continues to recover, many experts believe the Fed will start raising rates sometime in 2004.

ARMS are not for everyone but if they interest you give me a call at 909.515.5117 or 909.248.4830 x228 and I can help.

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