On Friday I asked
why ARMs were so expensive. I got a few responses, but the best was from an
anonymous commenter on Seeking
Alpha, "User 122506". His or her comment is worth quoting in full:
It seems the lending markets have a reduced appetite ARMs right now, with
rates (@3-5 yr) within 1/4% or so of a 30 yr fixed rather than a more "normal"
0.75-0.875% below the fixed. The more "normal" pricing would reflect
the lower cost of funding the ARM off the nearer term yield curve (for say
3-5 year ARMS) versus the longer term cost of the 10 year Treasury (off of
which 30 yr mortgages are priced).
Nomenclature point of order: Properly speaking, those rates you quote aren’t
"teaser" rates; teasers are significantly lower rates for a short
period of time (like a 1% or 2% rate for the first 3 or 6 months) which then
reset to the fully indexed rate, or to an initial fixed rate for some additional
interim period. The rates you list are plain old "hybrid ARM" or
"initial fixed rate converting to floating" ARM rates.
Your friend should stay away LIBOR based ARMs. Most of the time, the typical
pricing (LIBOR+225bp vs. 1-yr Treas+275) is very close to the same rate when
you hit the adjustment. But about once or twice a decade when credit markets
blow up (like recently) the spread of LIBOR-to-Treasury widens substantially,
and if your adjustment happens to occur during such a period you can pay quite
a bit more than if you were tied to the Treasury. (Also, now that I look at
it I think that is what is wrong with your table, which I didn’t quite understand;
after a return to "normalcy" at some point that 323 will pull in
closer to 275).
The short answer, then, is that ARMs aren’t normally as expensive as this –
that right now we’re going through a bit of an aberration. This makes a certain
amount of sense, given that default rates on ARMs are, for various reasons,
significantly higher than default rates on fixed-rate loans. Of course, that
doesn’t mean that any given individual is more likely to default if they get
an ARM as opposed to a fixed-rate loan, but that doesn’t matter: if you’re shopping
for a mortgage today, you should get a fixed-rate loan in any event, not an
ARM.
Now, will there come a point when ARMs become attractive again? I don’t know
– that standard floating rate of Treasury + 275bp still looks expensive
to me. But they will surely become more attractive than they are now.