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March 25, 2002
"I am trying to choose between different
adjustable rate mortgages (ARMs) offered by a local lender: 3/1, 5/1, 7/1 and
10/1 at rates of 6%, 6.125%, 6.25% and 6.375%, respectively. I plan to stay in
my house for at least 10 years. Which one is the best for me?"
The numbers you use to describe the ARMs
refer to the period for which the initial rate holds, and the rate adjustment
period after the initial rate period ends. On a 3/1, for example, the 6% rate
holds for 3 years, after which the rate adjusts annually. All these ARMs have
annual rate adjustments after the end of the initial rate period.
There is no "right" answer to your
question. The decision involves a judgment about the likelihood of higher
interest rates in the year ahead, and your ability and willingness to take that
risk. Higher rates on ARMs with longer initial rate periods can be viewed as
insurance premiums for longer protection. Rational people can have different
views on how much insurance they want to buy. I will indicate how I would go
about making the decision, but your answer might well be different.
The first thing you need to know is whether
these ARMs differ in respect to features other than the initial rate and the
initial rate period. All adjust the rate by adding a margin of 2.75% to the
one-year Treasury index at the end of the initial rate period, and each year
thereafter. In addition, on all of these ARMs, the maximum rate over the
lifetime of the mortgage is 6% above the initial rate. Since these features are
the same, they do not enter the decision process.
However, there is a difference in the rate
adjustment cap applicable to the first adjustment. The first rate adjustment can
involve an increase of no more than 2% on the 3/1 and 5/1, and no more than 5%
on the 7/1 and 10/1. This is an important difference.
I approach this by first comparing the 3/1
with the 5/1. The question is whether 2 years of protection is worth a rate
difference of .125%? To me it is. If you took the 3/1 and banked the difference
in payment, the savings would only cover a rate increase to 6.35% at the end of
3 years. Any increase larger than that makes the 3/1a loser relative to the 5/1.
I opt for the 5/1.
I then compare the 7/1 with the 10/1. If it
is worth paying an additional .125% in rate for 2 years of protection, then it
is worth paying the same amount for 3 years of protection. I opt for the 10/1.
Finally, I compare the 5/1 and the 10/1.
Here, the question is whether .25% difference in rate is worth 5 years of
protection. In this case, however, the larger adjustment cap on the 10/1 reduces
the protection. The largest possible increase in the rate on the 5/1 is 2%
whereas the rate on the 10/1 could increase by as much as 5%. For this reason, I
opt for the 5/1.
But these decisions are all quite close. The
reason you are having trouble making a decision is that the varying amounts of
risk in these ARMs has been carefully priced by the lender. The ARMs are priced
so that the lender is indifferent which one you select, and it is not surprising
that many borrowers might be equally indifferent.
If the different ARMs were offered by
different lenders, you could find larger price differences that could lead to
easier decisions. On the other hand, comparing ARMs offered by different lenders
is complicated by the fact that the ARMs may have different indexes, margins or
lifetime rate maximums.
Copyright Jack Guttentag 2002
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