Brooke Marion has more than 15 years of experience in the mortgage industry and she joined Mr. Cooper in 2011 as a loan originator — but her passion for connecting with people led to her role as our social media community manager. With her knowledge of so many aspects of the business, Brooke can help break down the mortgage process — and you might even find her answering your questions on Twitter and Facebook! Get in touch with Brooke at [email protected].
To refinance or not to refinance — that is the question. If you’re one of the millions of homeowners who purchased or refinanced your home between 2004 and 2008 using an adjustable rate mortgage (ARM) program, then you might be facing a dilemma. With interest rates on the rise since 2016, rates on existing ARMs are finally catching up. You may be asking yourself, “Should I continue to ride it out, or is it time to say goodbye to my adjustable rate mortgage and lock into a fixed rate loan?”
Generally when you think of buying a home, you think “30-year fixed” — that’s because it’s the most popular type of mortgage in the U.S. There other options for fixed rates (15- and 20-year fixed, for example); however, there can be benefits for homeowners to consider other programs (like ARMs). For starters, an ARM usually comes with a fixed period — anywhere from 3 to 10 years — before it becomes adjustable. We often refer to these as “hybrid” ARMs.
But what happens when your fixed period expires? Do you immediately have to refinance? Not necessarily.
First, let’s brush up on some of the basics. There are many types of mortgage programs out there, including ARM and fixed rate mortgages. I speak to homeowners daily, and many of them get very nervous by the prospect of an ARM — and I don’t blame them. Adjustable rates sound scary, right? Well, it depends on who you ask.
A HISTORY LESSON
Many of you may remember the “refi boom” in the early 2000s. Rates had dropped from historical averages north of 8% in the 1990s and were closing in on the 5% range. With the help of deregulation, credit requirements loosened and American homeownership rose to all-time highs. Even if you had credit issues, there were lenders offering programs for you — does the word “subprime” sound familiar? Many of these loans carried higher risk and, as a result, higher rates.
After years of what seemed like a free-for-all in the homebuying sector, the risky mortgages began to catch up (many of which were more “exotic” types of ARM loans). In 2007 and 2008, default rates grew, and global markets began to fail. With lenders and banks facing liquidity issues, homeowners took the brunt of the “credit crunch” and found it almost impossible to obtain financing for a home. Foreclosures grew, too, which further sent home prices into a tailspin. The government took unprecedented steps to save the housing market, including bailing out Fannie Mae, Freddie Mac, and many Wall Street giants. The Federal Reserve began a period of reducing interest rates.
BACK TO REALITY (AND SOME MATH)
Is your brain tired yet? Same. But this is where our original question comes into focus. After interest rates inched down, homeowners with ARM loans weren’t running to the nearest exit door to refinance once their fixed periods expired. And they didn’t need to. Their rates were going down — big time. ARM loans’ bad rap (volatility, insecurity, etc.) was now working in their favor.
It seems that no two ARMs are alike (well, they kind of are, but read on). When you first sign up for your ARM loan, your fixed period (3, 5, 7, or 10 years, in most cases) is just that – fixed. But what happens when that fixed period expires is important to understand — and also where many of us get lost.
Among the key factors that influence adjustable rate mortgages are margin and index. Don’t panic! These sound complicated, but I’ll break them down as simply as possible: what you can control vs. what you can’t control.
Margin: this is the “you can control” part. Your margin is set from the get-go. Margin is the percentage rate specific to your loan, and is predetermined in the closing paperwork. With most ARM loans, this number is 2.25%.
Index: This next component is a little more dicey — it’s the “what you can’t control” part. There are literally dozens of indices out there (sorry, the Webster dictionary had to complicate the plural form of index and spell it “indices”). We have the LIBOR, Treasury (MTA), and the Prime or Fed Funds Rate, just to name a few index influencers. To further complicate things, there are multiple versions of each of these: 1-month average, 6-month average, 1-year average, etc. Because these indices are based on global economic averages, there is no way to predict what’s going to happen to your index — I guess unless you’re an economist.
So, back in 2010 when rates started dropping, the index that your ARM was tied to also dropped — to all-time lows. One of the common indices that ARM mortgages are based upon is the 1-year LIBOR rate, whose acronym stands for the London Inter Bank Offered Rate. (Huh? Yep — many of your mortgages are at the mercy of an average of rates for a bank in London.) But to be fair, the Queen of England has nothing to do with it; LIBOR is still tied into the overall global market. But, I digress.
You can track the history of the 1-year LIBOR on several sites, but I like this one from Money Café because it gives you 10-year a historical chart, as well as a month-by-month breakdown. If you study it, you’ll notice that as we entered the recession in 2008, the LIBOR started dropping. It first hit a low of 0.72% in June 2011. This meant that, if your ARM had the typical margin of 2.25%, and your ARM rate came up for its annual adjustment that month, your rate would be calculated at 2.98% (calculate this by taking the value of the 1-year LIBOR index 0.72% + your 2.25% margin). This would be your calculated interest rate until the next adjustment (6 to 12 months, in most cases).
Um… does this scenario mean that my interest rate would be 2.98% for the next year? Sign me up!
And it didn’t stop there! With a few more fluctuations, the LIBOR dropped further – ultimately reaching its all-time low of 0.53% in June 2014. Now, you’d hypothetically get a rate of 2.78%. (Like I said… sign me up!)
SHOULD I STAY, OR SHOULD I GO?
All good things must come to an end, right? Well, let’s just say that the end of this one was like a long, slow breakup — and it was one of those “we’re better off as just friends” kind of breakups. The LIBOR index slowly began to creep up between 2014 and 2016, and by the beginning of 2017 as the new president was set to be sworn in, the LIBOR was up to 1.685%. Still not bad if you refer back to January 2008, when the LIBOR was 4.223%.
However, in 2017, mortgage rates in general were on the rise. And although homeowners with ARM loans were still comfortable with their yearly adjustments coming in around 3.9% to 4.25%, fixed rates were starting to creep up to that same average, around 4.25%. The stock market was in “bull” mode, hitting all-time highs month after month, and the question was now, “how much longer should I wait this out, and why would I want to give up my 3.5% ARM rate to refinance to a 4.25% fixed rate? The ARM has been so good to me!”
THE BAD NEWS
Since January 2017, the LIBOR has continued to snowball, finishing the end of September at 2.84%. Now (back to our math lesson) add that 2.84% to your 2.25% margin, and, yep, you guessed it: You are now facing a rate for the first time in almost 10 years that tops 5%.
We can call it a slow burn, but the fact is that homeowners’ ARM rates have steadily increased with each annual adjustment for more than 3 years. I speak to customers every day who, over the last 3 or 4 years, have ridden out their ARMs and watched as their rate climbed, for example, from 3%, to 3.5%, to 4.25%. And then BOOM: They just got another letter informing them of their next rate adjustment, to 5.125%.
With mortgage rates at a 7-year high, it’s tempting to continue playing your hand — to hold out hope that rates will take a downturn. With 30-year fixed rates averaging anywhere from 4.75% to 5.5% in some cases, homeowners are hesitant about refinancing — and all its associated closing costs, paperwork, and, yes, locking into an interest rate that will never go back down. It can seem like a lose-lose situation.
The reality is that no one really knows. No one has a crystal ball. Rates could go down, sure. But they could also keep going up. The real question we are faced with is, how much are we willing to gamble? Because at the same time, home prices are the highest they’ve been since the recession of 2008 and 2009; consumer debt is also at an all-time high. Whether we like to admit it or not, our household budgets are changing. Our kids want to go to college, we want to retire, and that beach vacation is long overdue. But if we don’t even know what our mortgage payment is going to be next year, in two years, and so on, setting a monthly budget and sticking to it can be a major source of anxiety.
At the end of the day, only you can decide what’s best for you. But, if you’re like me, gambling gives you heartburn. The housing market is still healthy, and the economy remains strong. And if you look at history to repeating itself, it usually means interest rates can’t stay low forever. If you’ve held onto your ARM for this long, you should give yourself a high-five — because you were probably playing your cards right. You could say you were beating the house. But in the words of The Gambler: You also got to “know when to fold ‘em.”
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