When putting together this
post I found out that the August 2014 rate on the 1-1 ARM was at the lowest
ever over the 2005 to 2014 period. This
rate only lasts one year. Taking it
over the 5-1 is tempting but foolish.
The indices used for ARM
adjustments are at a really low rate right now.
(The 1-year constant maturity treasury rate is 0.11 percentage
points.) When rates start at such a low
level even relatively modest movements towards the historic norm can create a
large payment shock.
Questions:
How have current interest
rates and monthly mortgage payments for the 1-1 ARM differed from the interest
rate on 5-1 ARMS and from the 30-year FRM ARM?
How have average interest
rates and monthly payments 2005- 2014 differed for the 1-1 ARM, the 5-1 ARM and
the 30-year FRM?
Consider a 1-year ARM linked
to the 1-year constant maturity treasury rate.
(It was 0.11 percentage points the last time that I looked.) What will happen to the payment on 1-1 ARM in
one year if the rate on the underlying index remains unchanged?
What is a reasonable
assumption on the level of this rate in one or two years?
What happens to 1-1 ARM
monthly payments in one or two years under this reasonable assumption?
Analysis of mortgage rates and payments:
Below is the information on
current and average 2005-2014 rates and monthly payments.
Mortgage Rates and
Payments
|
||
Rate August 2014
|
Monthly Payment
/August 2014
|
|
1-1ARM
|
2.37
|
($388.40)
|
5-1 ARM
|
2.97
|
($419.99)
|
30-Year FRM
|
4.12
|
($484.36)
|
Average Rate
2005-Present
|
Average Monthly
Payment 2005-Present
|
|
1-1ARM
|
4.06
|
($480.88)
|
5-1 ARM
|
4.43
|
($502.53)
|
30-Year FRM
|
5.10
|
($542.95)
|
Payments are based on a $100,000 loan.
Augusts 2014:
The person who chooses the
1-1 ARM over the 30-year FRM gains around $100 per month for a year.
The one-year gain for the 1-1
ARM over the 5-1 ARM is around $30 per month.
These differences only exist
for one month.
Historic Averages:
Difference between 1-1 ARM
and 5-1 ARM is around $22 per month.
Difference between 1-1 ARM
and 30-year FRM monthly payment is around $62.
Again these differences are
only guaranteed for one year.
Note on these calculations: Five years of
certainty is much better than one year of certainty. The payment differentials calculated here are
small. I suspect that people who are
taking the 1-1 ARM are not being offered the 5-1 ARM.
Discussion on Future Payments:
The 1-1 ARM is likely tied to
the one-year constant maturity treasury rate, which currently stands at 0.11
percentage points. It is likely that the
margin on this contract stands at 3.0 percentage points. If rates remain unchanged the interest rate
in one year on the 1-1 ARM will be 3.11 percentage points.
There will be 29 years left
on the loan so the mortgage payment should be amortized over 348 months. Plugging rate, period and loan balance
information into the payment function I get a monthly payment of $437.
In one year payments on the 1-1 ARM will exceed
payments on the 5-1 ARM even if the CMT rate remains at its current
ridiculously low level.
Rates are likely to move
towards their pre-crisis level soon. See
my recent post on likely rate movements.
Timing of market changes is
always very difficult. There is a
famous story about Keynes predicting the German Hyperinflation, shorting the DM
and losing money because he was too early.
I suspect that in 1 to 3
years the constant maturity treasury rate will be around 2.0 percentage
points. (Interestingly, rates have been
falling this past month. Timing is difficult.)
With the 1-year Constant
Maturity Treasury at 2.0 percentage points and the margin at 3 percentage
points the 1-1 ARM will pay around $545 per month.
This is a 40% increase in
payments.
Concluding Thoughts: The 1-1 ARM results in an
almost trivial savings compared to the 5-1 ARM.
The risks posed by the use of 1-1 ARMs to borrowers are always very
large. The use of 1-1 ARMs also
creates systemic risks to the financial system in the current
extreme-low-interest-rate environment.
When the interest rate on the underlying index is essentially near zero
relatively small movements towards the historic average rate can lead to a
large payment shock.
I don’t know the market share
of 1-1 ARMs but unless regulators get on the ball we may be closer to the next
subprime crisis than we realize.
I will be adding information
from this post and other posts on mortgages to my primer on adjustable rate
mortgages.
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