For those of you who’ve wisely taken out adjustable rate mortgages (ARMs) over the past 10+ years, pat yourself on the back. You’ve saved plenty of money by paying a much lower interest than if you took out a 30-year fixed mortgage. Getting a 30-year fixed mortgage has not been a financially optimal choice because most people sell after 7 years and the 10-year bond yield has been going down for the past 30+ years.
Even with the Fed finally raising the Fed Funds rate in December 2015, mortgage rates for NEW mortgages have declined by about 0.5% because the Fed doesn’t directly control mortgage or consumer lending interest rates. The market does. And right now, investors are piling into Treasuries due to fears of a global recession.
For anybody with an ARM mortgage, you need to read this post and refinance before your interest rate adjusts. Before December 2015, the Fed hadn’t raised rates since 2004 (see pic). As a result, most ARM holders blissfully saw their interest rates adjust flat to lower once the fixed period was over. Not any more!
I watch interest rates every day because the 10-year bond is in my portfolio. The stock market volatility of 2016 has seen Treasury bond prices surge as investors seek safety and liquidity. The 10-year yield collapsed to near all-time lows in 1H2016, but is marching higher as we enter 2021.
Japanese Government Bond yields now have negative real interest rates (same with Australia and Sweden), which means deflation might be back. From an economist’s point of view, nothing is more evil than seeing prices go down and having everyone believe prices will continue to go down. Consumption and investment grinds to a halt, and the economy gets stuck in a death spiral.
Adjustable rate mortgages and 30-year fixed mortgages closely track the 10-year government bond yield. Back in January 2015, I was able to successfully lock in a 2.25% 5/1 ARM jumbo loan with Chase. Unfortunately, they rejected me two months later due to the inability to recognize my freelance income.
So far, after checking online with LendingTree, and checking offline with Citibank and Chase, the best 5/1 ARM jumbo loan I can get is 2.375% and zero points. That’s still pretty damn good, since my current 5/1 ARM is at 2.625% and expires in mid 2021. That said, it’s still not the same as the 2.25% I got in January 2015 even though the 10-year yield is at the same level.
The likely reason? Lower margins. It seems banks are no longer accepting as small a profit margin as they were back in 2015 because banks are today more cautious about our future economic well-being. Makes sense. Over the past couple years, bank stocks have gotten hammered. Further, I think most of us are far less bullish than we were a year ago.
When I asked my banker for details about my current 2.625% 5/1 ARM loan, she responded with the following information:
First Adjustment: 6/1/ 2021
Index: LIBOR (index as of this week: 1.14%)
When I asked her to confirm whether this meant my mortgage interest rate would be equal to Margin + Index = 3.39% if the first adjustment was today, she said YES. I spoke to the loan officer for 45 minutes to clarify all information to help provide the best information possible for this post.
Going from 2.625% to 3.39% is a whopping 29% increase! This means a $1,000,000 mortgage monthly payment would rise from $4,017 to $4,429 according to LendingTree’s mortgage calculator. On the flip side, if I refinance down to 2.375%, payment would go down to $3,887 a month from $4,017. Saving $130 a month is nice, but the real benefit is saving myself from having to pay 3.39% and $542 a month extra after 6/1/ 2021!
For those who don’t know, LIBOR is the average interbank interest rate at which a selection of banks on the London money market exchange are prepared to lend to one another. LIBOR comes in 7 maturities (from overnight to 12 months) and in five different currencies.
The LIBOR interest rate is used as a base rate by banks and other financial institutions. Rises and falls in the LIBOR interest rates can therefore impact interest rates for savings accounts, mortgages and loans. However, notice how your money market savings account still hasn’t really risen as much. That’s because banks want to keep their costs low and realize they don’t need to entice new deposits because everybody is fleeing risky assets.
It is common to assume that so long as the 10-year yield would remain low, any adjustment in an ARM would simply adjust at the same rate or lower. After all, everything is interrelated in finance. The reality is, the interest rate adjustment all depends on what your ARM is indexed to. Most ARMs are indexed to LIBOR.
LIBOR moves very closely with the Fed Funds rate because both rates are SHORT TERM rates. See how LIBOR jumped by roughly 1% since July 2015 after the Fed raised the Fed Funds rate by only 0.25% in December 2015. That is a crazy jump!
The logical assumption is that LIBOR will now probably decline as the Fed isn’t raising rates as aggressively after such a volatile year and uncertainty with the election. At the beginning of 2016, the market believed the Fed would raise rates by 4 times. Now, a second rate hike is unlikely. LIBOR should stop rising so much, but it hasn’t.
If your ARM so happens to adjust during this LIBOR spike, then you’re unlucky because adjustments often lock for the next 12 month period.
1) Find out what your mortgage interest rate’s margin and index. The most likely answer is that your ARM is indexed to the 12 Month LIBOR rate. If your ARM were to adjust today, the new rate will equal the margin + index.
2) Once the mortgage interest rate adjusts, ask how often will the interest rate, and therefore your payment adjust. Some ARMs after their initial fixed period might adjust monthly according to the LIBOR rate. Most ARMs will adjust once a year. The worst is to have your ARM adjust during a temporary spike up in LIBOR as we are seeing now and lock the higher rate for 12 months.
3) Ask what is the mortgage interest rate maximum lifetime cap is. Given your mortgage’s margin is fixed, the lifetime cap is really a protection on the index going too high. For example, my ARM’s lifetime cap is 5%.
4) Find out the current refinance rates for a 3/1 ARM, 5/1 ARM, 7/1 ARM, 10/1 ARM, 15-year fixed, and 30-year fixed and what your corresponding payments will be. I’ve found the 5/1 ARM to have the best mix of interest rate and duration security. You can do a lot to pay down your mortgage or improve your wealth in a five year time frame. I’m still not a fan of 30 year fixed mortgages because the interest rate is usually 1-1.5% higher than a 5/1 ARM. I hope everyone realizes by now that interest rates will stay low for a long time.
5) If you do refinance, clarify with the loan officer whether you are resetting the amortization schedule (start back to year 0 out of a 30 year amortization period) or keeping it the way it is (e.g. paid mortgage for 5 years, and will have 25 years left until the entire mortgage is paid in the new loan). It’s generally a good idea to keep your amortization schedule as everyone should try and pay off their mortgage before retirement.
6) Take the cost of the refinance and divide it by your monthly interest savings. At the minimum, the break even period has to be less than the duration you plan to hold the property. The sooner the break even period the better. As a general rule, my recommendation is for two years or less and/or an interest rate differential of at least 0.375%.
Refinancing your mortgage is the one beautiful thing everybody should do in an economic downturn. You certainly want to do this before you potentially lose your job! Once you lose your W2 income, you are dead to banks. I absolutely will be trying to refinance again now that the 10-year yield is back down, and my financials are stronger due to two years worth of consulting income and less debt.
I strongly believe most ARM holders DO NOT realize that once their ARM adjusts, the interest rate will be much higher than their existing rate due to a ramp in LIBOR. Do not be under the assumption that because the 10-year bond yield is collapsing, your ARM mortgage interest rate will cooperate.
To get the best mortgage rate, you must make banks compete against each other with written offers. The easiest way to get a whole bunch of offers is to apply for a no-commitment quote online. Either go with the best quote or use the information to get your existing bank to match or beat. This is exactly what I’m doing, and exactly what my Citi loan officer has requested from me. Banks do not want to lose your business.
Refinance Your Mortgage: Check out LendingTree for some of the lowest free mortgage rate quotes online for purchase or refinance. They’ve got one of the largest banking networks today. Rates have come down post election, and even after the Fed started hiking interest rates. When banks compete, you win.
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Updated for 2021 and beyond.