Thursday, October 2, 2014

Benefits and risks of 1-1 Adjustable Rate ARMS



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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