Adjustable Rate Mortgages - The Facts, The Figures, and The Future!
Darren Meade
August 25, 2006
Adjustable rate mortgages have been the “hot” or “exotic” product for many consumers for the past few years. Having low payment options for a fixed period of time has been rather attractive. In addition, home equity lines of credit were great when the Fed Funds Rate was 1%.
However, given the eightteen consecutive rate hikes by the Federal Reserve it is a great time to review your mortgage and explore your options. It is time to understand the current interest rate environment and decide if that adjustable rate mortgage is still the best loan for you. Let’s take a look:
In the next few years two trillion dollars in adjustable rate mortgages will convert. Presently adjustable rate mortgages make-up 40% of all mortgages nationwide. Moreover, in some areas, such as California, the percentage of adjustable rates mortgages hits 70%. Given the increase in interest rates, home equity lines are averaging 9.25%.
When the announcement was made that the new Fed Chairman was going to be “Big” Ben Bernanke, the bond market weakened. Why? Because he was known as the “Inflation Wimp” and there was worry, that Bernanke would not be as tough on inflation as Greenspan. However, Bernanke will continue to flex his muscle to prove that he is committed to keeping the lid on inflation.
Inflationary pressure is a worry for bonds. Basically, inflation erodes the value of the payment to an investor. Let’s take a look:
You write a mortgage to someone with your own personal funds. The borrower writes you a check for $2,000 per month and you take the money and buy goods and services. Over a few months time, you find that you are not able to purchase the same amount of goods and services with the same $2,000 per month. Due to the inflationary pressure and inflation rising, your buying power is worth less. Therefore, the Federal Reserve must increase interest rates. Inflation up – interest rates up / inflation down – interest rates down.
So, where are rates going? Big Ben Bernanke will flex some muscle to prove that he is committed to keeping a lid on inflation. He started with his first set and bumped the Fed Funds Rate by 25 basis points on March 28. Then on May 10th decided to demonstrate a second set with a power flex of an additional 25 basis points, and on June 29th hit us with a power-set packing an additional .25% , another in July bringing the Fed Funds Rate to 5.50%
It’s like Goldilocks, Bernanke is looking to make the economy not too hot, not too cold, but just right. Historically the Fed has gone too far and has had to cut rates within a short period of time. Longest period of time 7 months / second largest period of time 5 months. Interest rate hikes can take six months or more to filter into the economy. If Bernanke goes too far he could kill the “Golden Goose” (US Economy). Being he is in the most important financial position in the World, Bernanke will not want to go too far and pausing will allow him to determine if further rate hikes are required to contain inflation.
Let’s take a look at where rates are headed given the increase in interest rates.
Federal Reserve increased rates by .25% on July bringing the Fed Funds rate to 5.50%.
The .25% increase will bring Prime to 8.50%. The formula for prime is the Fed Funds Rate (5.50%) plus 3% = 8.50%.
Given that home equity loans are tied to prime, the average HELOC interest rate nationwide will be 9.50%. As most equity lines are prime plus 1%.
A large percentage of interest only loans or loans with initial fixed rate periods are tied to the 6 month LIBOR. This increase will bring the average rate on loan tied to LIBOR to 8.50%. Let’s take a closer look:
The 6-month LIBOR follows the Fed Funds rate closely and essentially is the Fed Funds rate plus .50. If the fed funds rate is 5.50% add .50, the 6-month LIBOR will hit 6.00%. Additionally, add the average margin of 2.50% to the 6 Month LIBOR and the overall interest rate is 8.50%.
The MTA is the second most popular index for adjustable rate mortgages and moves a little more slowly than other indexes. The MTA stands for Monthly Treasury Average and is calculated by averaging the preceding 12-month 1 year Treasury bill. This would be the index of choice given the current interest rate environment.
The COFI index has always been known a the “slow and safe” index. The Cost of Funds Index is made up of interest expenses of several deposits including checking, savings, money market, and certificates of deposits.
However, the slow / safe index theory is a misconception. Given the current Inverted Yield Curve, this index is actually more volatile than the MTA.
Let’s take a look. An inverted yield curve is defined as the yield on the 2-year Treasury note being higher than the yield on the 10-year Treasury note. Therefore, if you are a consumer looking to invest money into a certificate of deposit and the rate on a 6-month CD is better than a rate on a 3 year CD, you are most likely going to lock into the shorter term CD. As accounts renew faster and investors reinvest into short term CDs, the index becomes more volatile as the long term CDs are not keeping the average down.
Additionally, the media has been hitting the wires about the negative impact the inverted yield curve can have on the economy stating that based on history the inverted yield curve equals recession.
If you look back on history out of the last 10-inverted yield curves, only five predicted recession. Therefore, there is only a 50/50 chance of recession and clearly, there is no recession coming, here is why.
Although many investors prefer short-term investment options versus long-term investment options (given the current interest rate environment), the median age of baby boomers were born in 1946 meaning the majority will be sixty in 2006. As they approach retirement years, baby boomers will look for more conservative and longer-term investments versus shorter-term investments for income to keep income stable. That said, Pension Fund Managers would look to long term investment strategies for the baby boomer generation.
Lastly, Asia and Europe will continue to look to the US to invest in bonds as the yield is significantly higher than bond offered in Europe or Asia.
Adjustable rate mortgages are good for some consumers but understanding the loan and the potential volatility will clearly define which loan will meet your financial goals.
If choosing an adjustable, the MTA may be the best choice. Think of a roller coaster at an amusement park. The MTA being the last car and the LIBOR being the first car. The LIBOR will increase faster and the MTA will lag behind.
Consider combining a first and second mortgage. Even if the first mortgage is locked in at a low rate, appreciate the savings that you have had over the last few years. However, understand that given the 16 interest rate hikes, payments have increased substantially and combining the first and second mortgage may actually create a monthly savings.
Ask about a 2/1 buy down. This feature allows a consumer to buy down the interest rate for the first two years. For example, if the current interest rate is 6.75% for a 30 year fixed rate mortgage, you can buy down the interest rate to 4.75% the first year, 5.75% the second year, and 6.75% for the remaining 27 years.
Also, piggyback mortgages were hot when the Fed Funds rate was 1% and prime was 4% but, given the substantial increase to prime, PMI is a great alternative for loan to values greater than 80%. As you can increase the interest rate by .125%, finance the PMI, obtain a low fixed interest rate, and take advantage of the PMI being fully tax deductible.
Take the time to meet with your trusted mortgage advisor and get the facts about adjustable rate mortgages. Make sure the loan officer is able to explain the market, interest rate environment, and overall outlook for interest rates. Please note that we lend in all states, and would be happy to help you devise a mortgage plan.
Adjustable rate mortgages are great loans for the right person and financial situation. However, knowing the facts about an adjustable rate mortgage will help determine whether it is the right loan to meet your financial goals in the future.
Historically the Fed has gone too far with rate hikes and every time the Fed has hiked rates three times or more, the Fed has had to cut interest rates. In 2007, we may see the Fed starting to cut interest rates once again.
Fixed rate loans are still extremely attractive. Looking back just six short years, the average fixed rate was 9.00% in 2000.
Compilation Including Barry Habib seminars and Mortgage Market Guide.
However, given the eightteen consecutive rate hikes by the Federal Reserve it is a great time to review your mortgage and explore your options. It is time to understand the current interest rate environment and decide if that adjustable rate mortgage is still the best loan for you. Let’s take a look:
In the next few years two trillion dollars in adjustable rate mortgages will convert. Presently adjustable rate mortgages make-up 40% of all mortgages nationwide. Moreover, in some areas, such as California, the percentage of adjustable rates mortgages hits 70%. Given the increase in interest rates, home equity lines are averaging 9.25%.
When the announcement was made that the new Fed Chairman was going to be “Big” Ben Bernanke, the bond market weakened. Why? Because he was known as the “Inflation Wimp” and there was worry, that Bernanke would not be as tough on inflation as Greenspan. However, Bernanke will continue to flex his muscle to prove that he is committed to keeping the lid on inflation.
Inflationary pressure is a worry for bonds. Basically, inflation erodes the value of the payment to an investor. Let’s take a look:
You write a mortgage to someone with your own personal funds. The borrower writes you a check for $2,000 per month and you take the money and buy goods and services. Over a few months time, you find that you are not able to purchase the same amount of goods and services with the same $2,000 per month. Due to the inflationary pressure and inflation rising, your buying power is worth less. Therefore, the Federal Reserve must increase interest rates. Inflation up – interest rates up / inflation down – interest rates down.
So, where are rates going? Big Ben Bernanke will flex some muscle to prove that he is committed to keeping a lid on inflation. He started with his first set and bumped the Fed Funds Rate by 25 basis points on March 28. Then on May 10th decided to demonstrate a second set with a power flex of an additional 25 basis points, and on June 29th hit us with a power-set packing an additional .25% , another in July bringing the Fed Funds Rate to 5.50%
It’s like Goldilocks, Bernanke is looking to make the economy not too hot, not too cold, but just right. Historically the Fed has gone too far and has had to cut rates within a short period of time. Longest period of time 7 months / second largest period of time 5 months. Interest rate hikes can take six months or more to filter into the economy. If Bernanke goes too far he could kill the “Golden Goose” (US Economy). Being he is in the most important financial position in the World, Bernanke will not want to go too far and pausing will allow him to determine if further rate hikes are required to contain inflation.
Let’s take a look at where rates are headed given the increase in interest rates.
Federal Reserve increased rates by .25% on July bringing the Fed Funds rate to 5.50%.
The .25% increase will bring Prime to 8.50%. The formula for prime is the Fed Funds Rate (5.50%) plus 3% = 8.50%.
Given that home equity loans are tied to prime, the average HELOC interest rate nationwide will be 9.50%. As most equity lines are prime plus 1%.
A large percentage of interest only loans or loans with initial fixed rate periods are tied to the 6 month LIBOR. This increase will bring the average rate on loan tied to LIBOR to 8.50%. Let’s take a closer look:
The 6-month LIBOR follows the Fed Funds rate closely and essentially is the Fed Funds rate plus .50. If the fed funds rate is 5.50% add .50, the 6-month LIBOR will hit 6.00%. Additionally, add the average margin of 2.50% to the 6 Month LIBOR and the overall interest rate is 8.50%.
The MTA is the second most popular index for adjustable rate mortgages and moves a little more slowly than other indexes. The MTA stands for Monthly Treasury Average and is calculated by averaging the preceding 12-month 1 year Treasury bill. This would be the index of choice given the current interest rate environment.
The COFI index has always been known a the “slow and safe” index. The Cost of Funds Index is made up of interest expenses of several deposits including checking, savings, money market, and certificates of deposits.
However, the slow / safe index theory is a misconception. Given the current Inverted Yield Curve, this index is actually more volatile than the MTA.
Let’s take a look. An inverted yield curve is defined as the yield on the 2-year Treasury note being higher than the yield on the 10-year Treasury note. Therefore, if you are a consumer looking to invest money into a certificate of deposit and the rate on a 6-month CD is better than a rate on a 3 year CD, you are most likely going to lock into the shorter term CD. As accounts renew faster and investors reinvest into short term CDs, the index becomes more volatile as the long term CDs are not keeping the average down.
Additionally, the media has been hitting the wires about the negative impact the inverted yield curve can have on the economy stating that based on history the inverted yield curve equals recession.
If you look back on history out of the last 10-inverted yield curves, only five predicted recession. Therefore, there is only a 50/50 chance of recession and clearly, there is no recession coming, here is why.
Although many investors prefer short-term investment options versus long-term investment options (given the current interest rate environment), the median age of baby boomers were born in 1946 meaning the majority will be sixty in 2006. As they approach retirement years, baby boomers will look for more conservative and longer-term investments versus shorter-term investments for income to keep income stable. That said, Pension Fund Managers would look to long term investment strategies for the baby boomer generation.
Lastly, Asia and Europe will continue to look to the US to invest in bonds as the yield is significantly higher than bond offered in Europe or Asia.
Adjustable rate mortgages are good for some consumers but understanding the loan and the potential volatility will clearly define which loan will meet your financial goals.
If choosing an adjustable, the MTA may be the best choice. Think of a roller coaster at an amusement park. The MTA being the last car and the LIBOR being the first car. The LIBOR will increase faster and the MTA will lag behind.
Consider combining a first and second mortgage. Even if the first mortgage is locked in at a low rate, appreciate the savings that you have had over the last few years. However, understand that given the 16 interest rate hikes, payments have increased substantially and combining the first and second mortgage may actually create a monthly savings.
Ask about a 2/1 buy down. This feature allows a consumer to buy down the interest rate for the first two years. For example, if the current interest rate is 6.75% for a 30 year fixed rate mortgage, you can buy down the interest rate to 4.75% the first year, 5.75% the second year, and 6.75% for the remaining 27 years.
Also, piggyback mortgages were hot when the Fed Funds rate was 1% and prime was 4% but, given the substantial increase to prime, PMI is a great alternative for loan to values greater than 80%. As you can increase the interest rate by .125%, finance the PMI, obtain a low fixed interest rate, and take advantage of the PMI being fully tax deductible.
Take the time to meet with your trusted mortgage advisor and get the facts about adjustable rate mortgages. Make sure the loan officer is able to explain the market, interest rate environment, and overall outlook for interest rates. Please note that we lend in all states, and would be happy to help you devise a mortgage plan.
Adjustable rate mortgages are great loans for the right person and financial situation. However, knowing the facts about an adjustable rate mortgage will help determine whether it is the right loan to meet your financial goals in the future.
Historically the Fed has gone too far with rate hikes and every time the Fed has hiked rates three times or more, the Fed has had to cut interest rates. In 2007, we may see the Fed starting to cut interest rates once again.
Fixed rate loans are still extremely attractive. Looking back just six short years, the average fixed rate was 9.00% in 2000.
Compilation Including Barry Habib seminars and Mortgage Market Guide.
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