The real estate blog.

On this day two years and eleven months ago, Alan Greenspan made the now infamous observation that homeowners should use adjustable rate mortgages.

On February 23, 2004 Greenspan observed -

While borrowers can refinance fixed-rate mortgages, Greenspan said homeowners were paying as much as 0.5 to 1.2 percentage points for that right and the protection against a potential rate rise, which could increase annual after-tax payments by several thousand dollars.

He said a Fed study suggested many homeowners could have saved tens of thousands of dollars in the last decade if they had ARMs. Those savings would not have been realized, however, had interest rates shot up.

“American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage,” Greenspan said.

Unfortunately for Greenspan, interest rates did shoot up and at his own doing nonetheless! In June, 2004 Greenspan began a rate raising campaign forcing short term rates up from 1% to 5.25%.

Now the Fed seems committed to lowering rates and Greenspan’s advice makes sense today. It’s important to recognize the average homeowner stays in their current home for about seven years and many pay extra for the security a 30 year fixed rate provides. Unfortunately many people don’t take advantage of 15 year mortgages that offer lower fixed rates because these loans have a higher payment.

We’re getting very close to the point where adjustable rate mortgages are going to make a lot of sense, even in the face of so called “exploding ARMs.” The latest mortgage rate report indicates 30 year fixed mortgages and 1 year ARMs are about even. In the last week 1 year ARMs dropped to 5.51 percent while 30 year loans dropped to 5.49%. As the Fed continues its rate lowering campaign, we should see ARM prices drop to the point there is a big advantage to those types of loans.

Not every ARM is created equal. In fact, as many homeowners are finding out, the ARM is stacked against the borrower because when it resets, that new rate is often higher than a fixed rate would be. These are the “exploding ARMs.”

One ARM stands out to me and that is the FHA one year ARM. It is the only adjustable rate mortgage available that has the potential to go down when it resets. All others remain the same or go up when they adjust. Qualifying factors in the adjusted up rate, so there are no surprises for borrowers. The FHA one year ARM is tied to the Fed overnight rate, so Fed cuts do help owners of these loans. Additionally, this loan can only adjust one percent up, should the adjustment include an increase. Over the course of the loan, it can go up a maximum of five percent.

Right now, comparably priced FHA loans give the one year ARM an eighth point advantage. We should see that margin improve if the Fed continues to lower short term rates.