Lower rates easing burden for some ARM borrowers

While Congress and the White House continue working on how to help homeowners with adjustable rate mortgage resets that have sent monthly payments through the roof, some relief is already on the way, thanks to lower interest rates.

ARM rates tend to follow movements in the short-term federal funds rate, which the Federal Reserve has lowered by 3.25 percentage points since last September. The index used for most hybrid and one-year ARMS, the one-year Treasury Constant Maturity, has dropped 2.3 percentage points in that time.

How much does that help? ARMs typically tack a margin of 2.75 percentage points onto the TCM index rate. Thus, a 3/1 ARM that had an initial rate of 5 percent when it originated in May 2005 would have reset to 7 percent this month if interest rates had stayed where they were before the Fed started cutting rates last year (assuming that annual adjustments are capped at 2 points, which is typical of many ARMs). Instead, the Fed cuts have brought the TCM index down to 1.93 percent, which results in a slight drop in rate—to 4.625—when the ARM resets. The drop cuts the monthly payment on a $300,000 mortgage to $1,547 from  $1,610.

The rate cuts are “absolutely” helping ARM borrowers, says Keith Gumbinger, vice president of HSH Associates, a mortgage-rate publisher in Pompton Lakes, N.J. “Even where they haven’t completely obliterated rate increases, they’ve ameliorated them.”

Lower interest rates only go so far, however, if the terms of the loans are stacked against the homeowner, as is the case with many subprime ARMs, according to data in a recent study (PDF download) by the Federal Reserve Bank of New York. For example, the 2/28 ARM, a subprime loan offered by New Century Financial, the second-biggest subprime originator in 2006, charged a “teaser” rate of 8.64 percent on average the first two years before resetting. Like many subprime mortgages, this one was tied to the 6-month London Interbank Offered Rate (LIBOR) index, with a whopping 6.22 points added as a margin.

So if last September’s 5.4 percent LIBOR rate remained in effect this month, this ARM would have reset to 10.13 percent. (A 1.49 point initial rate adjustment cap limits the hike somewhat.) Unfortunately, these loans reset every six months, so the rate would jump again to 11.62 percent in November (again assuming a 5.4 percent LIBOR). That would have added $6,610 to the mortgage’s annual cost.

With the recent rate drops, however, this ARM would reset to 8.9 percent (assuming the applicable LIBOR for a May reset remains where it stands now and for the rest of this year). That still increases the annual cost of the mortgage, but only by $770. “Subprime borrowers are not getting a lot of relief, but they’re no longer getting hammered,” Gumbinger says.

As if the New Century 2/28 was not anti-consumer enough, it also came with an interest rate floor equal to the teaser rate and a lifetime rate cap of 15.62 percentage points. Fortunately, 2/28 mortgages are now virtually defunct.—Jeff Blyskal