DEE-fense! DEE-fense!

Whenever mortgage rates rise quickly, most borrowers are tempted by adjustable rate loans and their lower starting rates.

The strategy has merit, but often not as much as asserted by some mortgage salespeople. Herewith a guide to terms and tactics, and a simple equation to help you decide if an ARM is an appropriate defensive tool in your particular situation.

The first adjustable mortgages were invented in 1980. In the first dozen years, the one-year ARM was predominant, carrying a starting “teaser” rate typically two percent or more below current fixed rates. Borrowers gradually learned to take advantage of a weakness in the product- if I can save two percent in the first year, why not refinance every year?

Borrowers should take advantage of lenders whenever they can, of course, but lenders countered, demanding prepayment penalties or mandatory origination fees, and the one-year ARM has fallen into disuse.

Enter the “hybrid” ARM. Hybrids are fixed for an initial multi-year period, and then convert automatically to one-year adjustables. (Note- hybrids should not be confused with the dangerous five- and seven-year balloon loans, known as “5/25s and 7/23s”.)

In mortgage slang, hybrid ARMs are identified as “three-ones, five-ones, seven-ones, and ten-ones.” The first number refers to the length of the fixed interval, which is priced with a modest teaser rate below fixed rates available at the same time; and the “one” refers to the conversion to one-year ARM status.

The initial hybrid rate advantage over fixed loans — the spread — changes every day with changing short- versus long-term spreads in the credit markets. The wider the fixed-to-hybrid spread, the more useful the hybrid.

There are four distinct circumstances where borrowers should consider a hybrid.

First, when you’re sure you won’t own a home longer than the fixed interval in one of the hybrids, the planned sale will protect you from the risk of upward adjustment.

In this case, when choosing the length of the fixed interval, remind yourself that not all housing markets are as hot as this one has been, and it can take a year or more to get your price. Many a family has acquired an unintended rental property when transferred, and it’s embarrassing to have the mortgage rate adjust upward in such a predicament. Note also the correlation between rising interest rates and lousy markets for homes.

The second opportunity for a hybrid is when the fixed-to-hybrid spread is very wide — for any reason. Overall interest rates were dead low in 1993, but hybrid spreads gaped canyon-wide, as much as two whole percent.

The third useful spot is for big loans. Higher, “jumbo” costs kick in at $240,000 for today’s fixed-rate loans, but not until $350,000 for hybrids.

Fourth, on every borrower’s mind in 1999, is defensive use of hybrids to avoid a sudden spike in fixed rates.

There are days when I think more consumers are losing money while playing defense than are saving any. The shock from a rapid rise can cloud the mind, and encourage a borrower to take a hybrid beginning with seven-something because eight-something fixed is too painful to contemplate, no matter what the real economics of the deal may be.

For open-ended ownership of a home, defensive use of an ARM by definition requires a refinance when rates come back down. If not refinanced, the ARM presents more risk than the rate spike in the first place. Unlike normal, optional, fixed-to-fixed refinances, the required refinance from the defensive hybrid may not save any money at all.

Example- if I took a 7.50% five-one today instead of an 8.00% fixed, I should surely refinance to a fixed any time rates again fell near 7.00% — the long-term low, aside from that V-shaped bit last fall. This refinance, a rate improvement of .50% or less, would not be economical in itself, as it would take several years to recapture costs.

Since the costs of the ultimate hybrid-to-fixed refinance are not self-supportig adjustment at the end. Bythen you will probably have refinanced anyway. The high caps allow the lender to make up for a big mistake inthe first five years; in return, the lender gives you a cheaper first five than tight caps would allow.

Trade away the periodic cap for a low life cap. You can still find ARMs with a life cap in the elevens if you’llshoot craps from year to year.

It is very desirable and very expensive to buy down the margin. Margin is a big deal because it’s a fixed cost ineach adjustment. Breakeven for buydown tends to be three and a half years — when it’s allowed.

Keep your intentions clear about how long you will own the house, how long it may be until the next refinancingwindow, and what the Fed is up to. Don’t ever be tempted into an ARM at a bottom in rates, or frightened awayat the best time- at a high in rates, or rising into one.