Short ARMs: A better Choice

There are some universal truths we count on in mortgage discussions. Annual percentage rate, or APR, is generally described as being "higher" than the stated interest rate. Because loans cost money to originate and the ARM calculation incorporates the fees into the rate. And adjustable rate mortgages, or ARMs, are always depicted as carrying a "low" start rate or "teaser rate," which then "increases" when it adjusts. These statements are completely untrue today. Short-term funds are so cheap now that ARM start rates are frequently higher than their adjusted rates. Some are resetting today down to less than four percent!

And that changes the APR calculation as well. Because when the APR is calculated, it is assumed that the rate will adjust to current rates (the financial index its tied to plus a margin of generally between 2 and 3 percent) at the end of the introductory period. Right now, those indexes are near zero. So normally an adjustable rate mortgage or hybrid ARM would be more desirable with a longer introductory period, today, the shorter the better. For example, Freddie Mac's average 1-year ARM start rate is 4.92%. But if adjusting today with the 1-year Constant Maturity T-Bill index at .61%, a loan with a margin of 2.75% would be adjusting to 3.36%, assuming that it didn't have a rate floor (limit to how low it can go). If the loan has a floor rate of 4%, that is the lowest the interest rate will go regardless of what happens in the financial markets.

So in today's environment, those who have short-term goals and don't plan to keep their property for many years could be well-served by getting an ARM with no floor or a very low one. And a short introductory period is better than a long one. So a 3-month ARM based on the LIBOR index could start at 4% today and be adjusting down to 3.25% in three months. Why would you want a 5/1 hybrid ARM and be stuck at 5.5% for years?

Liz Freeman has more than a decade of mortgage lending experience. She writes about mortgage and finance issues and is a regular contributor to Mortgage News Daily and other publications.