Eschewing Conventional Wisdom, Economist Says Now is the Time For ARMs

Challenging conventional wisdom, a Merrill Lynch economist says homeowners who opt for fixed-rate mortgages over adjustable-rate mortgages today might regret it.

According to the San Francisco Chronicle, Sheryl King contends borrowers tend to pile into fixed-rate mortgages at precisely the wrong time — just before the Federal Reserve starts cutting interest rates.

It’s similar, she says, to the way in which investors tend to pile into stocks at the peak of the market.

Today, more borrowers are choosing fixed-rate mortgages, mainly because they don’t cost much more than adjustable-rate ones.

But Merrill economists predict that the economy will soon weaken and the Federal Reserve will start cutting interest rates early next year. By the end of 2007, adjustable-rate mortgages will be significantly cheaper, but borrowers who try the mortgage refinance process then could hit problems.

• Consider that adjustable-rate mortgages are tied to short-term interest rates, which follow the federal funds rate.
• At the same time, fixed-rate mortgages follow long-term rates, such as the 10-year Treasury bond.
• Long-term rates, meanwhile, are set by the bond market and don’t always follow short-term rates.

After the Federal Reserve started raising the federal funds rate in June 2004, homeowners started abandoning adjustable-rate mortgages “in droves,” says King.

In mid-2004, ARMs accounted for almost half of all mortgage applications measured by dollar volume, according to the Mortgage Bankers Association. Last week, they accounted for only 39 percent, including hybrid loans that are fixed for a number of years, after which they begin floating.

That means 61 percent of homeowners are now opting for fixed-rate mortgages, which is not a shock.

The yield curve is relatively flat, meaning there’s not much difference between short- and long-term interest rates. Nor is there much of a gap between adjustable and fixed-rate mortgages. When interest rates are low and the yield curve is flat, borrowers have traditionally favored 30-year fixed-rate mortgages.

“At that point, there is little benefit for taking on the risk of an adjustable rate. Right now, that’s rational behavior. The value is still in a fixed-rate mortgage,” says Greg McBride of Bankrate.com.

Today, you can get a 30-year fixed-rate home loan for about 6.4 percent. You can get an ARM tied to the one-year U.S. Treasury bill for around 6 percent.

“That 6 percent is most likely a teaser rate,” says McBride.

Most loans of this type are priced at 2.5 percentage points above the one-year Treasury bill rate, which is about 5 percent today.

“If your initial rate is 6 percent and today’s one-year Treasury is 5 percent, you’re getting a 6 percent rate in a 7.5 world,” McBride said.

“A year from now you face the first rate adjustment. In order for your rate to drop to 6 percent at the first reset, you’d need the one-year Treasury to fall from 5 percent to 3.5 percent a year from now,” McBride said.

King says a drop in mortgage rates of that magnitude is not unthinkable. Merrill’s economists predict that the Fed will reduce the federal funds rate, now at 5.25 percent, by 1.25 percentage points by the end of 2007.

So why not simply get a fixed-rate mortgage today and then refinance into a cheaper mortgage if rates come down?

King says if the economy is indeed weaker, borrowers might be earning less or have no job at all, which could preclude refinancing.

Moreover, if the housing market continues to weaken, as Merrill forecasts, their homes could become worth less than what they owe. In that case, they might not be able to roll their mortgage refinancing costs into the new loan, which could kill the deal if they couldn’t come up with these costs in cash.

“From what we have seen over the past 15 years, it is obvious that a mass exodus from floating-rate mortgages usually occurs just before the Fed starts cutting rates,” King said. “Once a rate-cutting cycle kicks in, households generally flock back into ARMS. On average, the move back … starts about three months after the first Fed rate cut.”

King says she can’t recommend any types of mortgages over others, but it’s pretty clear from her report that she would favor taking out an ARM and ride the rate down. She admits that this is a contrarian view and would require a pretty good drop in rates to pan out.

Mike Fratantoni, senior economist with the Mortgage Bankers Association, says “our macro forecast is for the Fed to hold steady at 5.25 percent for the next couple years. Right now the risk between economic risk and inflation seem pretty balanced… We expect fixed rates will increase modestly over the next few years.”

Keith Gumbinger, vice president of HSH Associates, says it would depend on the situation what advice he would give borrowers.

“If you are in an ARM that is causing you pain there are choices today to alleviate that pain,” he said. “If you took out a 3-1 hybrid ARM three years ago, you probably got a fixed rate of 4 percent for three years. Now it’s coming due to adjust. Your rate is absolutely going to go up, but with a 3-1 ARM there is usually a 2 percent limit on your adjustment. The worst you can get is 6 percent. There’s no reason to refinance, because you will get higher rates in the market. Looking down over the next year, the Fed may indeed begin to lower rates.”

“Lots of borrowers have longer-term hybrids. In 2004, the most- popular product was the 5-1 ARM. Those borrowers don’t face any interest-rate adjustments until 2009. There’s certainly no reason to run out the door and disturb that,” he added.