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Does Your ARM Hurt?
Not yet, but it's about to.
The world of interest rates is changing fast, and the new financial condition is similar to the one that caused the creation of ARMs in the first place: a tightening Federal Reserve.
I can claim to have been present at the birth of your ARM. At the time, I was a sort of attending physician, along with other real estate brokers consulting with lenders in the design of the very first adjustable rate mortgages.
The first ones appeared in 1980, were not common until 1981, and the modern types were not invented until 1984.
ARMs are barely ten years old, now, and interest rates fell in nine of those years.
What happened in 1979 that spawned the ARM?
In a traditional fight against inflation, the Fed began to raise the Fed funds rate, just as it is doing now.
In 1979, most American mortgages sat in the collective belly of 7,000 Savings and Loans. The loans yielded about 9.00%, and the earnings from them allowed the S&Ls to pay their depositors about 7.00%. The other 2.00% went to salaries, rent, lights, paper, and profit.
In 1979, inflation was a serious problem. The Fed raised the Fed funds rate to 10%, then 13.5% by the end of 1979, then to a peak of 19% in July of 1981, and did not reduce this rate below 10% until October 1982.
When the Fed raises the Fed funds rate, it drives up other rates, particularly short term ones. When Fed funds crested at 19%, S&Ls had to pay 17% for a six-month certificate of deposit. By then, their loan portfolio yields were barely 12%. Three years of paying more interest than they earned, and the industry was history.
ARMs then and since have been designed to protect surviving S&Ls, banks, and any other institution in the mortgage investment business from periods of a tight Fed. If S&L loan portfolios had been full of ARMs in 1979, S&Ls would still be in business.
The most common modern ARM is tied to the yield on one-year Treasury bills, an instrument with a yield typically a little higher than the Fed funds rate. (There is another, less-common index known as "Cost Of Funds," which is often oversold as "slow moving" and "stable." It requires an article by itself, and a more cautious sales pitch.)
Each year on the anniversary date of your closing, the loan servicer looks up the prior four week average of one-year T-bills, and adds a "margin" to it, usually 2.75%, which generates the interest rate you pay for the next year.
This calculation is limited to a change of plus or minus 2% per year, and generally six percent over the life of the loan.
ARMs are not as popular as fixed rate loans, so lenders give away a low initial interest rate, known in retailing as a "loss leader" (Easter only! Nikes $5.00 per pair!), and in the mortgage business known as a "teaser" rate or, cruelly, a "hook" rate.
This low initial rate makes ARMs a great deal -- no matter what the Fed's up to -- if you plan to own the home for only a short while, to rapidly pay down the loan, or as a defensive tool at the peak of a rate cycle.
But, what about all the people who took out ARMs a few years ago, and still have them?
Last year, one-year T-bills paid about 3.30% (a thirty year low, by the way). Therefore, your payment adjustment last year was 3.30% plus 2.75% margin, and a pay rate about 6.00%. That was a pretty good deal: six percent was more than a percent under the average 30-year rate in 1993, though about 2.00% above prevailing teaser rates for new loans.
By March this year, as the Fed has raised the Fed funds rate, the yield on one-year Treasurys has gone up to 4.30%. For those of you with an anniversary date this month, 4.30% plus 2.75% means you'll pay 7.00% next year, still a percent under the rate you can get right now for 30 years, fixed.
Now the zillion-dollar question. How far is the Fed going to raise the Fed funds rate?
Ahem. The Fed's moves from 3.00% to 3.25% and then to 3.50%, as efforts to reassure investors about future inflation, have been a total failure. While the Fed has nudged .50%, bond and mortgage yields have soared a full percent in a vote of no confidence.
If it turns out that the gods of bonds are right, and the economy is growing too fast, thereby baking inflation into the future financial cake, the Fed has a long ways to go.
If the Fed has to take the Fed funds rate to 6.00% by early next year, one year T-bills will rise to maybe 6.75%. Plus 2.75% margin says you should have to pay 9.50%; but your cap from 1994's 7.00% saves you, and you only have to pay 9.00%.
But what happens if the Fed has to go to 8.00% (under the average of the 1980s), and stay there for a while? You wind up protected only by your life-of-loan cap at maybe 10.50% (or eleven, or twelveÉ).
Nobody can predict what the Fed will be doing next year. However, ten years of falling rates have lulled a lot of people to sleep. And it would be remarkable if we made it through the next ten years without some reversal of form.
If the bond pessimists are right, there will be some people who wished they had replaced their painful ARM with something more comfortable, and permanent.
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