Homeowners with adjustable rate mortgages always face a tradeoff. While low starting rates can be attractive, the prospect of inflation and an accompanying interest rate increase looms. But does this mean you need to fix your rate immediately?

The Economy Is Weak, But ARMs Are Strong

Adjustable Rate Mortgages (ARMs) are clearly not the safest home loan choice--according to the Mortgage Bankers Association, nearly 12 percent of grade-A (not subprime) borrowers with ARMs are in default on their loans, compared to only 2.75 percent of those with fixed rate mortgages. Borrowers who took out Option ARM loans with very low starting rates and racked up a lot of negative amortization are suffering--some payments have more than doubled.

However, those with conventional or hybrid ARMs are celebrating. The average rate for borrowers whose start rates have reset or adjusted is now 4.66 percent. And those who are resetting shortly should do even better. The 1-year CMT (Constant Maturity Treasury), a widely-used ARM index, was down to 1.12 percent on November 21^st. Adding a typical 2.75 percent margin to this results in a rate of 3.82 percent! Lower short-term mortgage rates are the silver lining in the dark cloud of a deflationary economy.

The Great Divide: ARM Interest Rates versus 30-Year Fixed Rates

Current 30 year rates, while low historically, are significantly higher than ARM rates--making refinancing from an ARM to a fixed rate mortgage an expensive proposition. And history seems to be on the side of ARM loans: rates dropped during the course of four of the last five recessions. So those with ARMs can be fairly safe in assuming that their rate should remain low during the current recession and could even decrease further. However, when recessions end, rates typically tend to rise.

So how do you know when to refinance? Refinancing from an ARM to a fixed rate mortgage almost always involves a compromise. The fixed interest rate will be higher. But unless you plan to sell your home soon, you may probably want to lock in a fixed rate before the recession is over.

Knowing When to Refinance

Historical data from 1985 to 2007 shows that the spread between ARMs and fixed rate mortgages ranged between .5 percent and 3.5 percent. Fixed rates today are at about 6 percent, resulting in a 2 percent spread that can probably be improved on. Mortgage rates are determined by the demand for mortgage-backed securities, and in the wake of the foreclosure crisis the demand for these investments dropped dramatically. The expected infusion of cash from the recently-enacted bailout into the mortgage-backed securities market may well close that gap and make moving into a fixed rate home loan a more attractive proposition.

So there should be no rush to refinance from an ARM today. Assess interest rates, spreads, the economy, and your changing plans periodically so you don't miss your best refinancing opportunity.

Sources

HSH

Investopedia

Martin Capital

Seacoast National Economic Perspective

Volokh

Yahoo Finance Composite Bond Rates