Expensive ARMs: An Answer

On Friday I asked

why ARMs were so expensive. I got a few responses, but the best was from an

anonymous commenter on Seeking

Alpha, "User 122506". His or her comment is worth quoting in full:

It seems the lending markets have a reduced appetite ARMs right now, with

rates (@3-5 yr) within 1/4% or so of a 30 yr fixed rather than a more "normal"

0.75-0.875% below the fixed. The more "normal" pricing would reflect

the lower cost of funding the ARM off the nearer term yield curve (for say

3-5 year ARMS) versus the longer term cost of the 10 year Treasury (off of

which 30 yr mortgages are priced).

Nomenclature point of order: Properly speaking, those rates you quote aren’t

"teaser" rates; teasers are significantly lower rates for a short

period of time (like a 1% or 2% rate for the first 3 or 6 months) which then

reset to the fully indexed rate, or to an initial fixed rate for some additional

interim period. The rates you list are plain old "hybrid ARM" or

"initial fixed rate converting to floating" ARM rates.

Your friend should stay away LIBOR based ARMs. Most of the time, the typical

pricing (LIBOR+225bp vs. 1-yr Treas+275) is very close to the same rate when

you hit the adjustment. But about once or twice a decade when credit markets

blow up (like recently) the spread of LIBOR-to-Treasury widens substantially,

and if your adjustment happens to occur during such a period you can pay quite

a bit more than if you were tied to the Treasury. (Also, now that I look at

it I think that is what is wrong with your table, which I didn’t quite understand;

after a return to "normalcy" at some point that 323 will pull in

closer to 275).

The short answer, then, is that ARMs aren’t normally as expensive as this –

that right now we’re going through a bit of an aberration. This makes a certain

amount of sense, given that default rates on ARMs are, for various reasons,

significantly higher than default rates on fixed-rate loans. Of course, that

doesn’t mean that any given individual is more likely to default if they get

an ARM as opposed to a fixed-rate loan, but that doesn’t matter: if you’re shopping

for a mortgage today, you should get a fixed-rate loan in any event, not an

ARM.

Now, will there come a point when ARMs become attractive again? I don’t know

– that standard floating rate of Treasury + 275bp still looks expensive

to me. But they will surely become more attractive than they are now.

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