When to Lock In That Adjustable-Rate Mortgage

Two years ago I took out a $450,000 adjustable-rate mortgage (ARM) indexed to the one-month London Interbank Offered Rate Index (LIBOR ). It had a margin of 1.375%, and I paid 7.5% during the first month. The loan adjusts every 30 days, with no monthly cap on how much it can move. Over the life of the loan, my rate can be no lower than 3% and no higher than 13%.

Currently, my rate has slipped to 3.5%, where it's been for the past couple months. I've used this low rate to pay off additional principal and now have a balance of $424,000 with 28 years remaining.

I plan to remain in my house for between 15 and 40 years. My wife has a stable position as an anesthesiologist, and I am currently an at-home dad who trades a lot. How do you calculate when to lock in a fixed-rate loan when your ARM is at 3.5%? Any thoughts from you or the experts on a situation like this? Surely I am not alone.
-- J.L.

You are not alone.

As the economic recovery picks up steam, ARM rates will rise, causing many to consider refinancing into more stable fixed-rate mortgages. When the Federal Reserve eventually hikes the federal funds rate , a variety of short-term rates used to determine ARM rates will jump. But when the Federal Reserve cuts rates, ARM rates slide -- a situation you took advantage of in the past two years.

When you took out that ARM two years ago, the rate on a 30-year fixed-rate mortgage was 8.39%, according to mortgage-tracker HSH Associates. Because you needed a jumbo (a loan that exceeds the size limit set for purchase or securitization by the appropriate agency such as Fannie Mae (FNM Quote) or Freddie Mac (FRE Quote)), the rate was probably 25 basis points higher, or 8.64%.

Instead, you chose an ARM whose rate varied with LIBOR, an average of the interest rates that international banks charge each other. Initially, your fully indexed rate was 7.5%, LIBOR's rate of 6.133% added to the loan margin (a static percentage that is added to the index rate, in this case LIBOR) of 1.375%. In exchange for the low rate, you accepted the risk that it could rise significantly.

That risk paid off. The rate on the LIBOR ARM hasn't topped 8.2% in the past two years, and it hit lows in the mid-3% range for the past six months. You took advantage of the lower rates, accelerated loan payments and now have a loan balance of $424,000. If you had stuck with the fixed rate, it would have taken you until April 2006 to reach that balance.

"He's been enjoying a tremendous run. The planets have aligned for this particular borrower. He's got the best rates in at least 10 years," says Keith Gumbinger, vice president with HSH Associates.

What Now?

With your rate in the mid-3% range, changing mortgages today would be a bad idea. According to Bankrate.com, the average rate on a 30-year fixed-rate jumbo loan is 6.73%, almost double what you currently pay. "That's such a great rate. If he were my client, I'd tell him to keep it," says Russ Marinello, a mortgage broker with Bay Counties Financial, in Burlingame, Calif.

But your 3.5% rate will vanish soon. The federal funds futures market has fully priced in the chance that the Fed will hike rates at its June meeting. Once the Fed acts, Gumbinger says, LIBOR will rise to levels seen in the mid-1990s. "The mid-5% range would be normal for LIBOR. Currently, that rate is one-third of where it has been in the last few years," he says.

(For more on how the Fed will affect rates, read ""What the Fed's Moves Will Mean to Your Loan.")

Because you have a large loan, no monthly cap and LIBOR as an index, you face enormous risks. Of all the ARM indices, LIBOR is one of the most volatile, as the chart below indicates. "You're going to have extreme savings when LIBOR is low, and extreme overpayments when LIBOR is decent," says David Kasprisin, vice president of National City Mortgage Services. "You're on thin ice. You're gambling, and when you gamble, you lose -- it's just a matter of when."

LIBOR's Volatile Nature Usually, the Cost of Funds index is the most "stable" while the LIBOR swings the most; the one-year Treasury is the "standard"

Source: HSH

And so, to your question: "How do you calculate when to lock in a fixed-rate loan when your ARM is at 3.5%?"

Deciding

It all comes down to rates and risk. If LIBOR returns to the mid-5% range, where it was a year ago, you'll be paying nearly 7%, after you add the margin. But that's assuming LIBOR returns to normal. If LIBOR spiked even higher, as it did in November 2000, your ARM rate could rise above 8% -- and stay there. "The big dilemma is that as LIBOR starts to go up, so will the fixed-rate loans," says Marinello.

There's no way of telling where fixed-rate mortgages will be once LIBOR rises. But as it happens, loans that offer a fixed-rate period begin to look more attractive. "The best one would be the 5/1 ARM," says Ray Brown, co-author of Mortgages for Dummies.

Under a 5/1 ARM, rates are fixed for the first five years and vary in the sixth. As of Friday, a 5/1 jumbo ARM has a rate of 6%, according to Bankrate.com, lower than the rates for 15-year and 30-year fixed-rate jumbo mortgages. Brown says that when it comes time to refinance, the five-year fixed portion will protect you from rate swings, while potentially offering a lower rate than fixed products.

Because you plan to be in your home between 15 and 40 years, a fixed-rate product more accurately reflects that long-term goal, HSH Associates' Gumbinger says. "You need to be aware that you've got a mismatch in goals here -- a short-term mortgage and a long-term horizon. Those two are not compatible," he says.

The bottom line: Watch LIBOR and switch into a more stable product as soon as the spread between your rate and fixed rates narrows.

"Think of rising rates like a train leaving the station. Right now, the train is beginning to creep out. If you wait until the train moves quickly, everyone is going to try and rush on," Brown says. "You'll be too late."