It’s the return of the adjustable

By Kenneth R. Harney | January 28, 2011 01:54PM

After years of virtual exile from the home loan arena, is the adjustable-rate
mortgage staging a quiet comeback? Could an ARM be on your shopping list the
next time you need to buy a house or refinance?

You might be surprised.

A new survey of 112 lenders by mortgage giant Freddie Mac found that
ARMs are starting to attract applicants again. Adjustables accounted for
just 3 percent of new home loans in early 2009, but are projected to be
the final choice for nearly one out of 10 borrowers in 2011. In the jumbo
and super-jumbo segments, the share will be even larger, according to Frank
Nothaft, chief economist for Freddie Mac.

How could this be, with fixed 30-year rates at half-century lows,
hovering just under 5 percent? Isn’t it axiomatic that it’s always smarter
to lock in a low fixed-rate for as long as possible rather than to gamble
on a loan whose rate might bounce around in the years ahead?

That logic still holds up for most people, but not for everybody.
Here’s why. The boom-era models of the ARM have pretty much disappeared —
there are no more of the two-year adjustables that hooked record numbers
of consumers in 2003 and 2004 with teaser rates that needed to be
refinanced with heavy fees within 24 months. No more “pick-a-pay” ARMs
that were mass-marketed with loosey-goosey underwriting and negative
amortization.

The most popular ARM in the market today, according to the Freddie
Mac survey, is the “5-1” hybrid. Its rate is fixed for the first five
years of the loan, then adjusts annually for as much as the next 25 years,
with protective rate caps to cushion payment shocks if rates suddenly
spike. There are also “7-1” and “3-1” hybrids. The antique one-year ARM
still is available but doesn’t get a lot of takers.

The real key to the growing popularity of hybrid ARMs is in their
pricing. Rates are significantly lower than fixed 30-year alternatives,
with no teasers or negative amortization involved. In some cases, they
also come with other attractive terms, such as more flexible underwriting
standards.

According to data supplied by Dan Green, a loan officer with
Waterstone Mortgage in Cincinnati and author of TheMortgageReports.com blog,
the rate spread between 5-1 hybrid ARMs and 30-year fixed-rate loans has now
widened to around 1.625 percentage points.

To illustrate, say you’re interested in a $250,000 conventional loan
to buy a house. You’ve got a 740 FICO credit score and want to close in 45
days. You could opt for a 30-year fixed loan at 4.75 percent, requiring a
monthly principal and interest payment of $1,304. Alternatively, you could
opt for a 5-1 ARM fixed at 3.125 percent, costing $1,071 in principal and
interest per month — a $233 saving.

But now check out the niche where hybrid ARMs really shine: Jumbo and
super-jumbo mortgages. Generally jumbos range from $417,000 to $729,750,
depending on home prices in your local market. Super jumbos can go into
the millions.

Say you need a $450,000 mortgage with a 45-day closing and you have a
740 FICO. According to Green, you should be able to get a 30-year fixed
rate jumbo today for around 5.625 percent. Monthly principal and interest
on a fixed rate jumbo would total $2,590 a month. Compare that with a
$450,000 hybrid 5-1 ARM: 3.5 percent for the initial five years, requiring
$2,020 a month in principal and interest. That’s a rate spread of 2.125
points — “the best we’ve seen in years,” said Green in an interview.
“It’s very aggressively priced” by banks who want to originate them to
hold in their own portfolios.

The savings go even higher in the super-jumbo space — a $1 million
5-1 ARM goes for 3.5 percent and saves a borrower $1,266 a month compared

with a competing $1 million fixed rate 30-year loan at 5.6 percent.

Cathy Warshawsky, president and senior loan officer of Bay Area Loan
Inc. in San Jose, Calif., cites another advantage for some jumbo borrowers
— special enhancements in payment terms. For example, a client of
Warshawsky’s needed a $950,000 mortgage at the lowest rate and monthly
payment. She signed him up for a 5-1 hybrid at 5.75 percent,
interest-only.

None of this is to suggest, of course, that hybrid adjustables make
financial sense for everybody. They don’t. But if you fit one of the
niches — you need a jumbo, you know you’re likely to be transferred or
you expect to sell the house within the coming five to seven years — they
merit a serious look.

Ken Harney is a real estate columnist with the Washington Post.