Are Adjustable Rates worth the risk?
Wealthy homeowners are discovering the upside to notorious adjustable-rate mortgages: big savings.
Most ARMs are originated with a fixed interest rate that lasts a few years before it becomes variable, then typically changing once every 12 months. But now, more jumbo borrowers are sticking with their adjustable rates after the initial fixed-rate period ends rather than refinancing into a new loan. The savings over time can be significant, since variable rates have been lower than fixed rates a homeowner who refinanced would get. And since they’re no longer refinancing, they don’t have to pay closing costs.
During the housing bubble, borrowers who didn’t shift out of ARMs before the rates changed often found themselves in hot water. Many of them ended up in foreclosure after rate increases made it harder for them to keep up with payments. Years of historically low rates, however, have made jumbo borrowers less fearful.
Thirty-seven percent of outstanding private jumbo ARMs no longer had fixed rates in September, up slightly from a year prior, according to data compiled for The Wall Street Journal by Lender Processing Services, a mortgage-data tracking firm. (LPS looked at loans that have at least a two-year fixed-rate period and that lenders hold on their books or sell to private investors rather than government-backed agencies.) This marks the fourth consecutive year that the share of these outstanding jumbo ARMs that have passed their reset period has increased: It was just 30% in September 2011 and 22% in September 2010.
Those figures are even higher with some lenders. PNC Bank’s Tyler Case, a senior loan officer in Red Bank, N.J., who originates mortgages for the bank’s wealth management clients, estimates that 40% to 50% of his private jumbo ARM borrowers have held on to their loans since the rates reset over the past three years. (In most cases, the reset happens automatically without the borrower having to take action.) Separately, NFC Mortgage Co., a mortgage lender based in Swansea, Mass., and a subsidiary of BayCoast Bank, says roughly 40% of private jumbo borrowers whose rates reset in the past 12 months have held on to the loan. “That’s the largest percentage of clients I have witnessed doing this in the past 17 years,” says Steve Romagnolo, executive vice president of business development at NFC Mortgage.
The biggest risk with an ARM is a rising interest rate, but borrowers are encountering the opposite scenario now. Variable rates on jumbo ARMs are lower compared with their loans’ initial fixed-rate and the rates borrowers would lock in if they refinance now.
Consider a borrower who signed up for a 7/1 jumbo ARM, which has a fixed rate for the first seven years of the loan, this week in 2006. At the time, the average rate on this loan was 6.21%, according to mortgage-info website HSH.com. The rate would now drop to 2.83%, assuming the mortgage rate is pegged to the one-year London interbank offered rate, which stands at roughly 0.58%, and that 2.25 percentage points are tacked on as the lender margin (a typical amount). That 2.83% is also lower than the rates of other mortgages that a borrower could refinance into: Rates on 30-year fixed-rate jumbo mortgages average 4.41%, while rates on new 7/1 jumbo ARMs average 3.33%, according to HSH.com.
To be sure, this all assumes that the borrower hasn’t yet refinanced the original mortgage as rates dropped to record lows and refinancing activity boomed in recent years.
Lenders say many jumbo borrowers were unable to get out of their loans since they owed more on their loan than their home was worth. In other cases, borrowers who had no trouble getting a mortgage before the downturn found it harder to qualify in recent years because they either could not provide all of the required paperwork or their income or credit score had taken a hit.
These borrowers now find they can lower their costs in several ways. In addition to a lower interest rate, they avoid closing costs, which are typically around 2% of the total loan amount when refinancing. To refinance a $1.5 million outstanding balance, that’s $30,000 in extra costs.
Still, borrowers face a significant risk. Should rates rise over the next year, they could get stuck paying a higher interest rate when the loan resets than if they refinanced now. Here are a few more issues to consider.
• Consider future plans: Some borrowers stay with the ARM after it resets because they plan on selling their home in the near future.
• Beware of freebies. Some lenders will refinance borrowers without charging closing costs but most will factor those costs into a higher interest rate than borrowers would otherwise receive.
• Extending repayment period. By refinancing, borrowers start the repayment period on a 30-year loan from the beginning. Monthly payments could shrink (since the remaining balance is spread out over a longer period), but the total interest they will pay by the end of the loan will almost certainly be more, says Keith Gumbinger, vice president at HSH.com.