To understand the factors that drive mortgage rates one should take a step back and examine how the value of a bond is determined.

All interest rates are determined relative to what is considered to be the real risk free market interest rate if no inflation were expected. This real risk free interest rate, which most consider to be the 90 day US Treasury bill, is the benchmark for how other market rates are determined. Unfortunately the majority of interest rates are not risk free; there are other factors that go into determining what the money you invest NOW will be worth in the future. This is the concept of “The Time Value of Money”. When placing a present value on your future cash flows you must consider several risks…these risks correspond to what you expect to receive in interest from an investment. That said, going back to how interest rates are determined…Remember all rates are based off of the “risk free” benchmark interest rate. On top of that to compensate for additional risks investors will demand additional interest based on the following…
1. Inflation Premium: If you invest $10 today and you expect the value of a dollar to be worth less tomorrow you will expect to be compensated for that loss of your initial investment. You will therefore demand a higher rate of return (interest rate). When inflation is expected to go up then interest rates go higher to compensate for the lost value of your principal investment.
2. Default Risk Premium: this portion of an interest rate is based off of the possibility that the person or company you are lending money to may not be able to pay you back. That is what a bond is after all, you are lending money to someone else, and in return you receive the interest rate plus the original money you lent them at a defined date. US Government Bill, Notes, and Bonds have a low default risk premium because the Federal Reserve can essentially print money to pay you back. Subprime loans have a high default risk premium because the chance that those borrowers will default on their loan is higher than a borrower with strong credit and stable income.
3. Liquidity Premium: If an investment cannot be quickly turned back into COLD HARD CASH it is said to be illiquid. The liquidity premium is based off the market demand for the type of debt (bond) you hold or issue. There is a massive demand for US Debt (bills, notes, and bonds) so if you wanted to sell your holdings of these securities it would be easy to find a buyer. If you hold the debt of let’s say a small company, it will be harder to find a willing buyer because for example information about that firm is not readily available to the public. When it is hard to find a buyer of the security you must lower the price enough to attract a willing buyer. This is said to be an illiquid security.
4. Maturity Premium: This compensates an investor for how long their money will be tied up in an investment …the longer the length of the bond contract (longer maturity) the more time there is for economic conditions to change. That means the inflation expectations may change or the ability of the debt issuer to service their loan may change as well. This is why the yield curve of US Bills, Notes, and the Long Bond is generally sloped upward. The clarity of economic expectations defines the maturity premium
So to put all this together…
Interest Rate = real risk-free interest rate + inflation premium + default risk premium + liquidity premium + maturity premium
NOW to relate all this to mortgages…In the most simplistic of explanations….the pricing behavior of a bond is as so : When there is more demand for a bond, meaning more buyers than sellers, the price of the bond goes up. When the price of a bond goes up the yield goes down until supply and demand reach equilibrium again (and vice versa). To oversimplify this happens because the price of the bond eventually becomes too expensive relative to the return that is received (the interest rate).
Although mortgage rates act similar to US bills, notes, and bonds….they do not operate the exact same way. Allow me to give some background first. The majority of mortgages that are sold in the US end up being securitized in some way or another. Usually they are put together in big groups of loans with similar interest rates and loan characteristics. Those pools of loans have a specific cash flow tied to them based on the average interest rate (coupon) of the mortgages that make up (back) the pool. When investing in that pool of mortgages, because you know what the average coupon rate, you know how much money you will get paid and when you will receive these cash flows. This is a broad description of mortgage securitization, or how your mortgage becomes part of a mortgage backed security (MBS).
Now that you have some MBS foundation, let’s build on it. How are the rates you are offered determined?
When economic conditions change or one of the above premiums changes these pools of mortgages either gain or lose value, meaning they become worth more or worth less. When those pools change value so do the interest rates you are offered when you seek to refinance or purchase a home. Here’s how: Every morning lenders publish a rate sheet and distribute it to loan officers who then offer you an interest rate. Depending on the time these rate sheets are generated, rates will either be better or worse based on the price the MBS pools are trading at when rate sheets are generated (more so dependent on when lenders locked (sold forward) their supply of loans). If “rate sheet influential” MBS are being bid up (price increases) mortgage rates will most likely be set lower compared to the previous day. If “rate sheet influential” MBS coupons are selling off, the mortgage rate you are quoted will likely be higher than the previous day.
Here is where things get a little more complicated. If the MBS prices go up and stay up, mortgage rates will move lower and lower (to a point where primary/secondary spreads can no longer tighten). If mortgage rates move lower there may be enough incentive for you to refinance your home. When refinance you are paying off your old mortgage and getting a new one with a lower interest rate, which restarts the securitization process. But here is the thing…the bank, money market manager, pension fund, insurance company, hedge fund, or servicer that invested in the pool of MBS that your loan partially backs then loses the cash flow that you contributed when you made your monthly payment (because you prepaid/paid off your loan early). This is the big difference between mortgages and other types of bonds like the 10 yr US Treasury….an MBS investor knows about how much cash flow they will receive and when they will receive it, what they don’t know is how long the cash flow will last due to the fact that borrowers have the ability to refinance their loan at any time (when they have incentive or need). This additional risk associated with mortgages is called prepayment risk, the option to refinance is an “embedded call option” within the mortgage-backed security. Prepayment risk adds a feeling of uncertainty to MBS investors; it distorts a portfolio manager’s ability to determine the present value of the expected future income streams that are generated from pools of mortgages, especially when interest rate volatility increases.
When rates are expected to be lower in the future, well I should say low enough to provide incentive to refinance or purchase, the pools of mortgages (MBS) that are backed by loans with higher rates will begin to lose more and more value as rates go lower and more borrowers refinance their loans (they prepay their loan or use their call option). Remember the income MBS investor expect to receive is generated when you pay your monthly payment, so if you refinance your loan MBS investors lose the income stream they were expecting you to contribute to the MBS pool. MBS investors therefore must find a way to replace that lost expected future cash flow. If a group of MBS investors believes rates will go lower then they may sell a portion of their higher interest rate (fuller) MBS portfolio in favor of lower rate pools to compensate for lost income (and need to extend duration of their cash flows if yield curve is flattening). They do so because they believe they will receive stable cash flows for a longer period of time (relative to liabilities..that is the investor must offset cash inflow duration with cash outflow duration).
How does this affect day to day mortgage rates?
When the yield curve fluctuates, a shift in coupon bias (duration bias) generally follows. This can result in either buying or selling “down in coupon” (when yield curve flattens) or “up in coupon” (yield curve steeper). Often times when selling a pool of MBS made up of mortgages with higher interest rates, investors will look to buy pools secured by loans with lower rates to stabilize their expected future cash flows. This is called a down in coupon day and is a major force in the daily price movements of mortgage backed securities. The same happens on up in coupon days but in that case MBS investors sell “rate sheet influential” MBS coupons and mortgage rates generally move higher.
To summarize when reading our commentaries you should understand that when we say prices of mortgage backed securities (MBS) are going up, that the rate you are offered as a borrower will go down. The MBS is subjected to the same premiums that determine the value of other types of bonds, except MBS are exposed to prepayment risk, the fear that an investor may lose future cash flows because a mortgage holder (borrower) decides to refinance their home. This additional risk often forces portfolio managers to extend the duration of expected future cash flows by either buying lower coupon MBS pools or perhaps purchasing less risky securities with more relative value. In times of economic uncertainty and increased interest rate volatility, forecasting the expected interest rate environment becomes a difficult task. Therefore the models used to determine the future value of cash flows generated by a pool of mortgages become inaccurate. This creates a volatile interest rate market and often times confuses borrowers as the why mortgage rates sometimes fluctuate in a wide range.

Lean times lighten property tax load

By Tom Opdyke
The Atlanta Journal-Constitution

Published on: 07/07/08

Here’s a weak ray of sun in a cloudy economy: The taxable value of most metro Atlanta homes is not going up this year.

Reflecting the extended slump in homes sales, it means that unless you made improvements or additions, your tax office doesn’t think your home’s value has increased. It also means your taxes could fall by a sliver —- probably less than $10 annually —- unless your county increases its millage.

As counties finalize their tax digests —- the value of all commercial, personal and residential property —- for the Aug. 1 state deadline, most metro governments, with the exception of Forsyth County, are reporting fewer assessment increases than taxmen have seen in two decades.

Tax bases are still rising in metro counties because of increases in assessed valuation for commercial property, new construction and a boost in a small percentage of residential property. But nothing like prior years.

“Until this current market, a saying of mine was, there was not a residential property going down in value. In this market, yes, there is,” Gwinnett County tax assessor Steve Pruitt said.

With the exception of Fulton County, which showed about a 16 percent increase in its digest and increased commercial assessments by a median 44 percent, most metro counties are reporting about 6 percent growth, some less.

The storm cloud surrounding this silver lining: slower growth in the tax base could foreshadow an increase in taxes or service cuts in coming years.

Because the assessments are based on market value as of Jan. 1, 2007 —- and the Standard & Poor’s/Case-Shiller Home Price Index shows the Atlanta resale market has fallen 6.5 percent since March 2007 —- assessors foresee smaller tax base growth in 2009 unless sales heat up.

“I do think 2009 will be a lot more challenging than 2008 for local government,” said John Scott, chief assessor in Bullock County and executive director of the Georgia Association of Assessing Officials.

Only property owners whose valuation changes get a notice from the tax assessor, and not all properties are evaluated every year.

Cobb and DeKalb counties mailed the fewest notices of assessment changes in two decades.

“It would be normal for us to mail out in excess of 100,000 notices on an average year. This year it was about 26,000,” said Tom Stump, interim chief assessor in DeKalb. For about 1,700 who received notices, assessment went down.

Forsyth sent about 56,000 notices, with about 43,000 showing increases. But they were the exception.

Cobb’s Board of Tax Assessors in March ordered no increases in residential assessments unless a property had been improved —- an addition, a new bathroom or the like.

Instead of sending out the year’s typical 70,000 notices —- about one-third of the county’s residential stock —- Cobb sent about 13,000, and about 2,300 were notices of decreased valuation, said chief assessor Phil Hogsed.

Most assessors said the valuation decreases were not in a particular area or city. In some areas, the types of houses in the same subdivision have changed.

In the Hays Farm subdivision in west Cobb, larger houses that sold in the $500,000 range are now near smaller homes by a different builder that sell in the $300,000s.

While the assessors are not permitted by law to use foreclosures as part of their calculations, they are sensitive to the impact of foreclosures on communities.

“If 30 percent of the sales in a neighborhood were foreclosures, we tried not to make any adjustments,” said Rodney McDaniel, Clayton County’s chief assessor.

FREQUENTLY ASKED QUESTIONS

Q: I have foreclosures in my neighborhood that I think are dragging down my property value, why is it not reflected in my real estate assessment?

A: Foreclosures are not directly considered in property assessments because the taxman is required by law to consider only sales between a willing buyer and seller. A foreclosure is viewed as a forced sale.

Q: How do I appeal my property reassessment?

A: Most counties have an appeal process outlined on the assessment notice you receive. An appeal must be mailed within 30 to 45 days of the notice’s mailing date, depending on the county. Counties often provide a form on their Web site so you can file electronically. Go to your county Web site and click on the link for the Board of Tax Assessors.

Q: If I didn’t get a reassessment notice but believe my property value has diminished, what can I do?

A: Probably nothing this year. Early next year —- the deadline can be March 1 or April 1, depending your county —- go to your tax office and file a real estate tax return. You also can obtain the form by going to http://www.etax.dor.ga.gov/ptd/adm/forms/pt.aspx and downloading form PT-50R. Tell the assessors what you think your property is worth. Assessors will review your property and your will get an assessment.

A QUESTION OF VALUE

A tax digest, which includes residential, commercial and personal property assessed at 40 percent of market value, is set by the county appraisers. They determine the market value of property but do not set taxes. Once approved by the state, it is used by the county, its cities and the public school systems as the basis for setting tax millage. Here is what metro counties reported:

Clayton

2007……$8.1 billion

2008……$8.5 billion

Increase..5.9 percent

Cobb

2007……$26 billion

2008……$27.6 billion

Increase..6.2 percent

DeKalb

2007……$23 billion

2008……$24.1 billion

Increase..4.8 percent

Fulton

2007……$54.4 billion

2008……$63 billion

Increase..15.8 percent

Gwinnett

2007……$27 billion

2008……$28.5 billion

Increase..5.6 percent

UBS: Atlanta, Charlotte, and Texas Will Be First to Recover
by Sarah Yaussi
From: BIG BUILDER 2008
Related topics: business, local markets
It may be too soon to call a bottom in the housing market, but that’s not stopping UBS from pinpointing which geographical markets will be the first to rebound–and which single-family and multifamily builders will be most able to take advantage of the turnaround in those markets.

In a new Q-Series report released this morning, UBS analysts David Goldberg and Alexander Goldfarb selected Atlanta, Austin, Charlotte, Dallas/Ft. Worth, and Houston as their top picks for markets that will lead in a housing recovery.

The outlook for those five markets was optimistic because they exhibited stronger positive trends in demographics, economic growth, affordability, and inventory than the other eight markets examined.

Based on these same metrics, Orlando, Las Vegas, Phoenix, Riverside, and Tampa fared the worst. For-sale inventories and declining home sale prices have increased competition among single-family builders, a fact that also poses hurdles for apartment fundamentals.

San Diego, Los Angeles/Orange County, and Washington, D.C., were identified as “coincident” markets, meaning they were somewhere in between market leaders and market laggards.

Using the results of this analysis, Goldberg and Goldfarb also calculated home builders’ and apartment REITs’ exposure to each market and were able to forecast which companies would be the best positioned for a housing rebound. Out of the nine public home builders in Goldberg’s coverage universe, The Ryland Group was the big winner. With the release of the report, Goldberg upgraded Ryland stocks to a buy status.

Ryland’s geographic diversification–it has no more than 10% of its business concentrated in any one geographic market–merchant builder model, and strong balance sheet puts it in a position to take advantage of a market return quickly.

Moreover, the company has a higher concentration in markets with more favorable outlooks and less of a presence in more troubled markets such as Las Vegas, Phoenix, and Tampa. In a related conference call, Goldberg pointed out that, based on community counts, Ryland has roughly 33% of its communities spread across top pick markets Atlanta, Dallas, and Houston versus an average of 24% for the group.

On the multifamily side, Essex Property Trust was Goldfarb’s buy-rated stock. He pointed to the company’s exposure in coastal California and Seattle–markets less affected by the housing downturn–as major pluses.

During the call, Goldfarb also pointed out that the market report was slightly more reflective of single-family building than multifamily activity. “A good apartment market is where single-family remains in check,” he explained. Thus, as the single-family market has struggled, the apartment industry has felt some fallout.

He also stressed this point in the report: “There has not been an influx of new renters as the housing market collapses–indeed we are seeing competition from rental homes in some markets. For example, 14% of Camden Property Trust’s move-outs in Las Vegas are to rental homes.”

Going and gone: Developers of Tribute Lofts decide to put units up for auction because the condo market was sluggish.

By Kevin Duffy
The Atlanta Journal-Constitution

Published on: 06/23/08

Caleb Atkins gave himself a heckuva birthday present Sunday: a two-bedroom, two-bath condominium on the top floor of the Tribute Lofts building east of downtown Atlanta.

Tribute sold 26 units in an unusual one-hour auction Sunday at the Omni Hotel at CNN Center. The developers, Greg and Brian Wohl, decided to go the auction route because the condo market is so sluggish.

In a year’s time, Tribute, which recently won a new-construction award from Atlanta’s Urban Design Commission, has sold fewer than half of its 147 units. Many of the condos put up for auction had been under contract, but the deals fell through.

“I’m about to go and celebrate pretty heavily,” said Atkins, a Georgia Tech graduate who works in Suwanee and turns 25 on Friday. “I prefer to live where I play.”

Even before learning of the auction, Atkins was planning to buy a Tribute condo and say goodbye to his house-sharing in Virginia-Highland.

“But two days before I was to make that offer, the auction was announced,” he said. “We freaked out. The two-bedroom unit that I couldn’t afford, I could afford now.”

Atkins is a homeowner for the first time. He paid $263,000 —- the highest price at the auction —- for the 1,306-square-foot unit. Atkins pointed out his winning bid was “30.77 percent” less than the original asking price of $379,900.

Initially, the Wohls and auctioneer Accelerated Marketing Partners intended to auction 40 units. But 10 units were nixed beforehand because registrants showed little or no interest in them.

Four more units were not offered for sale when the sellers ended the auction early; they feared prices might go too low as the crowd thinned. “We had gone as low as we could tolerate,” said Jon Gollinger, Accelerated Marketing Partners’ co-founder and East Coast chief executive officer.

Nevertheless, Greg Wohl said he was pleased because selling that many condos will stabilize the development and help his company pay off its construction loan.

The project still has about 40 market-rate units left to sell, which will be reduced in price as a result of the auction, Wohl said. Tribute also has 10 unsold affordable-housing units.

Representatives of two of Atlanta’s biggest condominium sellers, the Marketing Directors and Coldwell Banker the Condo Store, were on hand to observe the results.

The cheapest sale was $132,000 for a 795-square-foot one-bedroom unit that originally was priced at $183,900 —- a discount of 28.2 percent. Minimum bid prices for the one-bedroom, one-bedroom-with-den and two-bedroom units ranged from $110,000 to $198,000.

Paul Nichols, a 30-year-old software engineer and Georgia Tech graduate, earned a round of applause as the first winning bidder. He paid $144,000 for his one-bedroom unit.

Nichols said he plans to move there from Buckhead and enjoy the seventh-floor view while waiting for his new home to appreciate.

“And if it doesn’t,” he said, “America is in trouble.”

The rising cost of crude oil has everyone talking about gas prices at the pump… but what about the actual oil in your engine? Are you spending too much on oil by changing it too often?

Most of us probably think a car’s oil needs to be changed every 3,000 miles. But that’s an old mechanics tale these days. Did you know that many car manuals now actually recommend changing the oil every 5,000, 7,500 or even 10,000 miles? That means you may be changing your oil twice or even three times as often as you need to! In fact, a recent study in California indicated that 73 percent of Californians change their oil more frequently than recommended by the manufacturers.

So how often should you change your oil?

The fact is, oil changes should be determined by what, how, and where you drive. If you have a newer car with little or no engine wear, you can probably go 7,500 miles between oil changes. And even if you have a slightly older car, but drive under ideal conditions such as predominantly highway, you can go a similar distance before changing.

Of course, many of us actually don’t drive under “ideal” conditions…if you make many short trips, endure lots of stop-and-go traffic, drive on gravel or dusty roads – then you might need to change your oil more frequently. So how do you know – and take advantage of saving money by only changing oil when it’s really needed?

Technology to the rescue

There are a few ways you can actually eliminate the guesswork. If you have a newer car, it may have a built-in sensor that estimates oil life based on engine running time, miles driven, outside temperature, coolant temperature and other operating conditions. When the indicator light comes on, it’s time to change the oil. It’s that simple.

Another idea is to purchase an oil monitoring sensor, such as the IntelliStick. These sensors are used in place of your car’s original dipstick and provide you with real-time, accurate information about the true condition of your oil. Better still, these sensors often have a transponder built into them so you can quickly and easily check the condition of your oil at any time using a cell phone, PDA or computer with Bluetooth connectivity…now that’s really going high tech.

Bottom line – dollars spent on oil changes add up fast. Especially with the increasing price of oil, it pays to be smart, check the manufacturer’s recommendations…and not let too-frequent oil changes cost you!

Dog owners love their pets, but bathing them is another story. CityDog Market (404-816-8050 and www.citydogmarket.com) recently opened in Brookhaven at 4244 Peachtree Road. It offers an easy to use dog bathing facility, complete with pH-balanced shampoos and conditioners, ear cleaner, temperature controlled trigger sprayer, towels and a hair dryer, all for only $18 for 20 minutes in a state of the art stall.
CityDog Market specializes in natural and organic pet products, such as durable toys made out of recycled material, boiled wool balls that benefit an orphanage in Nepal and hemp rope bones, toys and collars. Their soft pet bedding is made out of recycled soft drink bottles and dog and cat food products are natural, organic and free of additives and byproducts.
For your pet loving acquaintances, buy a gift card or purchase an organic dog cookie or cupcake made out of wheat and soy. How about the brake-fast dog food bowl that slows down a dog’s eating? Come meet store dog Big Daddy and friendly owners Patsy McGirl and Renee Palmer. Hours are Tuesday through Friday 11:00am to 7:00pm, Saturday 10:00am to 5:00pm and Sunday 12:00pm to 5:00pm.
– Bob Rosentreter

Atlanta Business Chronicle – by Douglas Sams Staff writer

For decades, Peachtree Industrial Boulevard between Buckhead and Doraville was a stretch of highway marked by small manufacturing plants, warehouses and car dealerships — hardly the picture of city living.

But that picture is changing.

Developers are lining up along the corridor to launch real estate projects that could turn Peachtree Industrial into one of Atlanta’s hottest infill markets, with townhomes and condos from $300,000 to $500,000 and new stores. One of the latest sites that could fit that mold is Chamblee Plaza, a nearly 20-acre property being marketed for redevelopment.

Although the residential downturn could slow the corridor’s transformation, it is nevertheless under way — its potential spurred even more lately by rising gas prices, the public’s increased reliance on public transportation and developers writing new business plans that see transit-oriented developments as profitable pursuits.

The Brookhaven area today, with its schools, churches, shops, restaurants, businesses, residences, government offices and superstores is becoming ever increasingly more populated. Brookhaven traffic is getting thick and parking crowded, and the community is beginning more and more to resemble Buckhead.
As recently as the 1950s and early 1960s, however, Brookhaven was a rural area with woodland roads, and sometimes the best way to traverse them was by horseback. Nearby Chamblee was dairy country with plenty of pastureland for horses to graze. Along Mabry Road and Hermance Drive near Oglethorpe University, there were farms with horses, in places where there are condominiums and fine homes today.
A favorite place for Oglethorpe students to ride horses was at Silver Lake, which had numerous trails. Horseback riding was a part of the intramural sports program at Oglethorpe in the 1950s.
- Dr. Paul Hudson, longtime resident of the Brookhaven area and historian at Georgia Perimeter College, writes stories of Bygone Brookhaven regularly in the Buzz.

April pending home sales rise as prices tumble
Monday June 9, 11:00 am ET
By Joanne Morrison

WASHINGTON (Reuters) – Pending sales of previously owned U.S. homes unexpectedly rose in April to the highest level in six months as foreclosed properties flooded the market and drove prices sharply lower, a real estate trade group report on Monday showed.

The National Association of Realtors Pending Home Sales Index, based on contracts signed in April and seen as a key barometer of future housing activity, increased 6.3 percent to 88.2 from an unrevised 83.0 in March. Despite the uptick, sales were 13.1 percent lower than a year ago.

“Bargain hunters have entered the market en masse, especially in areas that have seen double-digit price declines,” said the association’s chief economist, Lawrence Yun. Regions of the country that have seen sharp price declines, such as the West, are now seeing a sales recovery, he added.

Economists polled by Reuters before the report were expecting pending home sales to decline 0.5 percent.

“We are seeing an acceleration in foreclosures. As foreclosures have taken off, they put pressure on prices. Banks have become more aggressive with sales on homes they have foreclosed,” said Christopher Low, chief economist at FTN Financial in New York.

Low said the pickup in pending home sales could be a sign that the housing market could soon be stabilizing.

“Sales will stabilize in the next few months and that will set the stage for inventories turning to normal sometime next year and maybe even for prices to appreciate a bit,” he said. “For now, prices will continue to fall. There is still an inventory overhang that will take 18 months to work through. The end game of the housing bust is near.”

The median home price fell 8 percent in April from a year earlier, according to a report from the National Association of Realtors last month, which was the second-largest price decline on record.

U.S. Treasury debt prices fell on Monday after the surprise jump in April pending home sales, while U.S. stock markets were up.

The unexpected rise could be the result of statistical reporting issues being disrupted from an earlier-than-usual Easter holiday week.

“The exceptionally early Easter meant that all the holiday disruption was in March, so April had more selling days than usual,” said High Frequency Chief Economist Ian Shepherdson, expecting the May data will reflect a sharp drop.

Todd Crane
Sunshine Mortgage
When Alan Greenspan says that Adjustable Rate Mortgage (ARM) loans were a better choice than fixed rate mortgages, people start to pay attention. So if ARM loans could have saved homeowners very significant amounts of money, why have Fixed-Rate products been the overwhelming favorite? The answer could be in the borrower’s lack of understanding, experience, or perhaps it is unjustified fear. Additionally, many loan professionals may not have adequately and articulately walked their customers through the pros and cons of an ARM loan. Once a borrower gains a better understanding of the proper way to make comparisons between loans that can adjust vs. those that are fixed, as well as the historical data, they may be much more open to selecting an ARM loan and reaping the benefits.
There are lots of ARM loans to choose from and the features can vary quite a bit. The time that an ARM will remain fixed before adjusting and the factors governing the future adjustments, including the maximum amount the rate can change are important points to consider. The future adjustments are based on an index, so understanding what will cause the index to fluctuate as well as historical data on the index are both important to know. Let’s look at one popular type of ARM…a 5/1. This loan will remain fixed for the first five years but then adjust every year thereafter. A common misunderstanding that many consumers will have is that they feel they should only consider the 5/1 ARM if they plan to be in their home for five years or less. They often fail to recognize that the savings made in the first five years will offset future years of possible higher payments if the rate on the ARM increases. The best way to illustrate this is to look at a specific example. It is very common for the rate of a 5/1 ARM to be about 1% lower that the rate on a 30-year fixed loan. Assume the loan amount were $300,000. The 1% savings on the 5/1 ARM would save the borrower about $200 each month for the first 60 months (5 years). That would net them a hefty savings of $12,000 during that time. But most borrowers worry about what will happen after the initial period. If the $12,000 savings during the initial five years were just placed in a piggy bank, there would be enough funds there to draw upon to cover future worst case increases for the following 2-3 years. This assures the borrower of coming out ahead by selecting the 5/1 ARM for 7-8 years. Compare that to the average life of a mortgage loan, which is four years (because people will refinance or sell their home) and the odds become stacked in your favor that the ARM will save you money.
Let’s Get Creative
Another strategy that can be used for the above mentioned example is to take the $200 monthly savings and use it to reduce the balance on the mortgage. The pre-payment of principal will have an even greater effect because the borrower is now skipping down the amortization schedule and paying more principal and less interest on each subsequent payment. After the initial 60 payments made during the first five years, the borrower would have approximately $17,000 more equity in their home because of the reduced principal balance. Because the borrower has this extra $17,000 in equity, they would be better off with their 5/1 ARM for approximately 10 full years. This is true if rates moved higher after the initial five years…even in the worst-case rising rate scenario. And, it just so happens that the National Association of Realtors states that the average period of time that people sell their residence is every 10 years.
Another benefit when using the strategy of reducing the principal balance happens at the time of the initial adjustment. When an ARM loan adjusts, it essentially becomes a new loan where the payments are based upon the remaining years, the new interest rate and the remaining balance. Because the remaining balance is significantly lower when the savings are used to reduce principal, the payment can actually go down even if the interest rate adjusts higher.
I Am Not a Gambler
Many borrowers say they refuse to take a gamble on their selection of a mortgage product so they stick with a fixed rate. Well, like it or not, whatever their choice is, it’s a gamble. Selecting a fixed rate still means they are betting that, during the time they are obligated to pay the mortgage, the fixed will perform better than the ARM. Either way, they are rolling the dice and making a bet. The only difference is they will know the result of the fixed payment. The key here is to get the odds to work in your favor. That is where understanding and guidance from the loan originator can be worth its weight in gold.
Back to The Future
They say a picture is worth a thousand words. The chart below may be worth thousands of dollars. Over the past 200-years, interest rates on the US 10-year Treasury Note have, for the most part, remained fairly tame. The average has been close to 6%, but many fear the chance of runaway double-digit rates. Rates have remained in the single digits for all except 8 of the 214 years shown below. The rampant inflation of the late 1970’s had to be reigned in. So rates were pushed higher during the 1980’s. The result…low inflation and rates over the years leading to the present time. The lesson learned by the Fed was to use an ounce of prevention instead of a pound of cure. In other words, the Fed acts quickly now to hike rates a little so that inflation will remain in check, which helps keep rates from running significantly higher. The sky-high rates of the early 1980’s will probably never be seen again.

I Agree With You But…
“OK OK”, says the borrower, as they appear to finally see the benefits of utilizing an ARM loan. But…”Even though I know I will have saved the money in cash or equity during the first five years, I still may be faced with significantly higher payments to make. Where will I come up with the extra cash flow to pay the higher payment of, perhaps, $500 per month?” The answer is simple but not obvious at first. Let’s understand what would make rates skyrocket for 8, 9, or 10 years. The overall economy would have to be very strong, almost too strong, to see inflationary pressures causing rates to ascend and remain very high. Much of those inflationary pressures would come from employment wages rising at a torrid pace…perhaps 10% per year or more. But let’s assume the borrower is on the very low end of pay increases, and only sees an average increase of 4% each year. If their household income were $80,000 today and they were concerned about the possibility of a $500 increase in monthly payment 9 years from now, it sure would appear scary against today’s income. But they really need to consider what their future income will be. Even at a very modest 4% annual gain, which could be less than half the average annual gain in a hot economic climate, their $80,000 annual income will swell to almost $110,000 in 9 years. That means they would have an extra $2,500 each month to help pay the additional $500 possible bump in their mortgage payment. Sound far-fetched? An easy way for your clients to relate to the increase in their future income is to work backwards. This same formula would mean that their income 9 years ago was $58,000…Not very hard to believe.
Void Where Prohibited, May Cause Drowsiness and Your Mileage May Vary
Almost all of the above examples were given under the worst-case scenario for the ARM loan. And the worst-case is not likely to occur. Even so, the results appear quite favorable when compared to the fixed. But, that said, the wide variety of ARM loan types and their specific features require that each loan option be examined individually…thus, the above disclaimer. But the key is for borrowers to have an open mind and explore the many options. Even a great rate on the wrong mortgage selection can be far more costly than a fair rate on the right mortgage product to fit the individual’s needs.
Remember…it’s not getting what you want that counts…it’s wanting what you get.