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Looking Ahead: A Growing Case For One-Year ARMs

Riverdale NJ, April 22, 2005 -- Largely out of favor in recent years, pricing trends may again make one-year ARMs a viable alternative for borrowers seeking just a little more stability than a very short-term ARM may allow. Those very short-term ARMs typically reprice on a monthly basis after perhaps a 3-month fixed period, and those adjusted rates have been landing in the 5%-6% range in the past few months.

Historically, one-year ARMs have found favor among borrowers when the differential in the initial interest rate of a one-year ARM, when compared against a 30-year FRM, approached or exceeded 2 percentage points (2%). In order to attract borrowers to a product which features a risk of rising interest rates, some form of discount was offered from not only a more preferred product (i.e. 30-year FRM), but also from the instrument's real ("fully-indexed") interest rate. This fully-indexed rate is typically determined by adding a margin of 275 basis points to the value of the one-year Treasury Constant Maturity, although other indexes and margins may be used.

The decline in short- and long-term interest rates though 2003 helped borrowers to ignore one-year ARMs in favor of fixed-rate products. Lenders, wary of making not only low-priced loans but loans which could feature below-market rates for an extended period, simply stopped pricing these aggressively.

The net result was that, from September 2001 through October 2003, the average initial rate for a one-year ARM was at or above what would have been its fully-indexed price. With no incentive to take the riskier ARMs, most borrowers found FRMs and other loan products far more attractive. In addition, the continuing advent of low fixed interest rates has largely kept borrowers away from these products, and lenders have shifted their marketing focus to mid-term Hybrid ARMs and very short-term ARMs, leaving the one-year ARM to languish.

Fast forward to recent market conditions. While the spread between a 30-year FRM and one-year ARM remains small largely due to the increase in short-term interest rates, that differential is about 150 basis points (1.5%) today. This means that a borrower could save a fair bit of money for at least one year by selecting a one-year ARM over a 30-year FRM. As well, the average rate for a one-year ARM is now about 150 basis points below fully-indexed, so lenders are once again offering products priced more aggressively than at any time since late 2000.

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