Who would take a variable rate mortgage?

Roger Schlesinger
Posted: Sep 12, 2006 12:57 PM

To begin with, I would. In fact, I have 3 variable rate mortgages on three different houses. I am using myself as an example because I want the reader to understand that what I recommend is generally something I will do for myself, first and foremost.

In a simpler explanation "I put my money where my mouth is." Variables are always around, but their popularity grows generally at times when interest rates are high, not when they are low. It is different this time because of an inverted yield curve making most variables as high or higher than fixed rates.

I believe that the inverted curve is about to adjust once the Federal Reserve signals that the raising of the interest rate, short term, is over and that the risk on interest rates will be to the downside, not the upside. So let's start examining variable rates in preparation. The major difference between fixed rates and variables is that a fixed rate is always fixed, or if it offers a lower rate to start, will have the exact formula in place before you take the loan. An example is a loan known as 2/1 buy down which allows the borrower to take a fixed rate, 30 year in this example, at a rate that is about 2% lower the first year, 1% lower the second year, and then a tad higher than a standard 30 year fixed for the remaining 28 years. The rates for this 2/1 buy down are currently in the middle 4% range for the first year, middle 5% range for the second year and middle 6% range for the remaining 28 years. A regular 30-year fixed, conforming loan is currently in the low 6% range.

Variables vary base on the value of the margin and the index which are added together on the change date. The borrower doesn't know what that will be until the change date. There are some variable loans that will have yearly caps, which only allow a certain percentage increase to protect the borrower, 1% every six months or 2% each year, but the borrower is still at a loss to know the exact rate until the change is made.

The big question is who would take these kinds of loans and why?

There are many answers to the question, but the favorite is a lower rate. Generally you can get a significantly lower rate by taking a variable rate loan.

There are three types of variables: straight, fixed and variable and potential negative amortization loans. The straight variables are those that generally vary monthly and are totally dependent on the index of that loan. Earlier I said margin and index but the margin is a fixed margin and the variance occurs only when the index moves. The lower the margin, the smaller the move. The fixed and variables are the hybrids which are fixed for 1 year, 2 years, 3 years, 5 years and 10 years before becoming variable. These are generally the most popular of the variables.

The negative amortization loans, my least favorite, can produce an ever-increasing balance because the payment is lower than the required interest payment. The difference between the two is added to your existing balance and you end up paying interest on interest. In subsequent columns I will delve into each type of variable in greater detail.

The main reason I am excited about variables, especially straight variables, is that they are out of favor and the margins are very low because of the disfavor. Once the variables become the loans to own, the margins go up or the prepayment penalties come out. At the present time you can take a straight Libor arm, tied to the one-month or six month Libor, and get a margin in the low 1% range. It will cost a point but it is a margin that can keep you low through the entire length of the loan. If you want, you can take a margin in the high 1% range and not have any points to pay.

The one month Libor can vary every month if the index changes, the six month Libor changes every 6 months if the index moves. Both loans can be paid interest only for 10 years. Although both loans are in the six percent range currently, they could start moving down in the next several months. Three or four years ago they were in the 2% range when the Federal Reserve lowered the short-term rate, Federal Funds Rate, to 1%.

Most strategic moves are made in life when the outcome is not clear and the timing is suspect. Being a contrarian is not easy but can be extremely profitable when you are correct. Fixed rates are great and most people need to remain in them, as the risk reward scenario doesn't work for them. Fixed rates, which are in the high 5's to low 6% range, offer great rates; but when, and if, interest rates go down only those who have variables really benefit. As I said many time before, "YOU get to make the choice". Make it a good one!

Roger Schlesinger's Mortgage Minute is heard on hundreds of radio stations and daily on the Hugh Hewitt radio show and Michael Medved shows. Roger interacts with his hosts and explores the complicated financial markets in order to enlighten his listeners and direct them along their own unique road to financial freedom. Roger is the President and founder of Manhattan West Mortgage.