Personal Finance: Don't risk arm and leg on an ARM
Does the shape of the yield curve mean anything to you? You might not think so, but if you're thinking about buying a house or refinancing your current one, and you're trying to figure out what kind of loan you want, it means a lot.
Looked at from a mortgage rate standpoint, the one-year adjustable rate mortgage is on the short end of the yield curve and the 30-year fixed-rate mortgage is on the long end. The spread between the two is generally the shape of the yield curve—normal, inverted, flat, etc. Economists and investors watch the shape as a clue to where the economy is headed.
Here's where the mortgage shopper comes in: When the curve flattens, meaning short rates are close to long rates, then it doesn't make sense to take out a loan that is based on a short-term rate, like an ARM. According to the Mortgage Bankers Association, the average rate on a 30-year fixed mortgage rose to 6.21 percent during the week ended October 28, and the one-year ARM hit 5.39 percent. A year ago, the 30-year was at 5.65 percent and the one-year ARM was 3.96 percent. So the spread between the longer rate and the shorter one has narrowed considerably over the last year, to 0.82 percent now versus 1.69 percent a year ago. The yield curve has flattened.
Short-term rates have been rising more rapidly because they're more closely tied to a benchmark interest rate set by the Federal Reserve, a rate the Fed has been hiking gradually for a year and a half and raised another quarter point Tuesday. That rate also eventually moves long-term borrowing rates, but so far long rates have not moved as quickly as short-term ones have.
People take out shorter-term and adjustable rate mortgages because the interest rates on them are generally lower. In exchange for a cheaper loan, they assume more of the risk that rates will rise in the future. The longer fixed-rate mortgages cost more but have the guarantee that the rate will not change for the life of the loan.
The cost to fix your rate for 30 years, however, is now only about eight tenths of a percentage point, or as Mike Fratantoni, an economist at MBA, puts it, "almost nothing." Even hybrid loans, ARMs that are fixed for five or seven years before they start adjusting, "aren't that great a deal as the yield curve continues to flatten," says Fratantoni. Thus, the advantage of going with an adjustable rate loan is greatly reduced.
Bottom line: The 30-year fixed mortgage is probably the better deal right now. You'll pay only a tiny premium for it, and you might sleep better at night.
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