ORLANDO FLORIDA — ORLANDO, Fla. -- Despite all the tutti-frutti flavors of home loans that financial theorists have dreamed up in recent years, most homebuyers are sticking with plain old vanilla: the 30-year, fixed-rate mortgage.
However, now might be the time to try another flavor: the one-year adjustable-rate mortgage. Despite its inherent risks, the one-year ARM actually has been a better deal during the last five years, and mortgage experts say the outlook is rosy for the next five years.
One-year ARMs are being offered at between 4 percent and 6 percent. In some cases, that is a full four percentage points under the prevailing 30-year fixed rates. With the standard built-in caps that prevent payments from going too high, a buyer who borrows ARMs now faces a relatively mild worst-case scenario.
As attractive as that might sound, most borrowers still shy away from one-year ARMs, lenders say. Many homebuyers lost their taste for one-year ARMs in the early 1980s when soaring interest rates revealed their negative potential. Monthly payments rose -- sometimes dramatically -- as provisions kicked in to protect lenders from inflation.
A spate of exotically structured home loans -- known by acronyms such as PLAM and LIBOR -- followed in the mid-1980s, designed as alternatives to one-year ARMs. Theoretically, they were supposed to be less expensive than one-year ARMs or offer more stability.
But during the past two years, the recession-plagued economy has checked inflation -- cutting 30-year fixed rates to 19-year lows -- and has banished most out-of-the-ordinary mortgages to the history books.
Many lenders still offer alternatives such as five-year and seven-year balloon notes, which amortize like 30-year loans except the balance comes due after a specified period.
But most homebuyers, remembering that fixed rates stood at 10 percent and 11 percent just a few years ago, are borrowing today's 7.5 percent to 8 percent fixed-rate loans by better than a 2-1 margin over other types of loans, according to industry experts.
Elizabeth Clarke, vice president of secondary marketing at Princeton Financial Corp., an Orlando mortgage banking firm, said most of the mortgages being taken out this summer are refinancing existing mortgages. Most borrowers are taking out 30-year, fixed-rate loans to cut their payments or 15-year, fixed-rate loans to cut their mortgage terms, Clarke said.
As of Aug. 21, 30-year fixed-rate loans were offered across the nation at an average of 7.87 percent interest, according to the Federal Home Loan Mortgage Corp., or Freddie Mac. The national average for one-year ARMs was 5.2 percent.
What's the difference between an 8 percent fixed-rate loan and a 5 percent one-year ARM? For one thing, the one-year ARM makes it easier to
buy a house.
At 8 percent, it would take a $32,400 annual income to borrow an $85,000 mortgage, according to Arlo Croxall, principal partner at Contemporary Mortgage in Altamonte Springs, Fla. At 5 percent, the income requirement drops to $24,900. That assumes that the borrowers would pay the standard 28 percent of their monthly income toward a mortgage payment.
"For people in the affordable house price range, that's a significant difference," Mr. Croxall said. "I think there are a lot of people out there who can afford to buy a house but don't think they can because they're only looking at the fixed-rate products."
Of course, what keeps consumers away from ARMs is the fear that interest rates will rise again, resulting in increased mortgage payments. That would happen if inflation struck the economy again, which, in turn, would force the federal government to pay higher interest on Treasury securities. The index most lenders use to calculate ARM adjustments is based on an average rate paid by the government on one-year Treasury bills. The worst-case scenario is that the rising payments would outstrip consumers' incomes.
That fear is not unfounded, given the experience of the late 1970s and early '80s, when the one-year T-bill index skyrocketed from 5 percent in January 1977 to 14.03 percent in March 1980.
But many economists believe that those inflationary years were an aberration, and inflation is not likely to soar that high again.
"If you take a long-term look at interest rates throughout this century, there's really only one period in which rates were out of control. That was 1980 and '81," said Martin Regalia, chief economist for the Savings and Community Banking Association in Washington.
"Unfortunately, that's right about the same time ARMs came on the market. A lot of people were burned when interest rates went so high and people in their 30s and 40s still remember it. That's why there's still so much resistance to ARMs today."
But the more recent track record for ARMs -- the past five years -- shows a downward trend. An $85,000 ARM borrowed at the prevailing rate of 8 percent in June 1987 would have started out with monthly principal and interest payments of $623.70, but by now the payment would be $587.27.
On the other hand, with a 30-year, fixed-rate loan borrowed at the June 1987 rate of 10.7 percent, the monthly principal and interest payment would have remained constant at $790.27 over the years.
Of course, that loan could be refinanced to obtain today's lower fixed rates, but the borrower would have to fork over closing costs of between $1,000 and $2,500. And then, the loan term again would be at 30 years instead of 25.
For the ARM borrower, though, the key question is what happens from this point on. In this example, the borrower of the 1987 ARM faces a potential lifetime cap of 6 percent over the initial rate.