Mortgage borrowers look for stability

NEW YORK (CNNMoney.com) -- Freddie Mac, the government sponsored enterprise created to add liquidity to home-mortgage markets, reported Monday that borrowers with adjustable rate mortgages (ARMs) are overwhelmingly choosing to switch to fixed-rate loans when they refinance.

During the three months ended June 30, 85 percent of these borrowers with one-year ARMs switched to fixeds. Hybrid ARMs borrowers who refinanced were similarly inclined; 86 percent opted for fixed rates.

ARMs helped fuel a mortgage meltdown the past few months, with many more borrowers unable to make mortgage payment as their interest rates soared after resetting and housing prices slumped.

One-year ARMs usually carry low initial rates the first year and adjust annually after that. The reset is limited to 2 percentage points or so and the lifetime cap - the maximum it can increase above the initial rate - of about five or six points.

Hybrid ARMs, often called "exploding or toxic ARMs," carry sometimes extremely low ("teaser") rates for the first two (2/28 ARMs) or three (3/27 ARMs) years and adjust every six months after that.

They also come with limits on how much they can reset (often 3 percentage points for the initial reset and 1 percentage point after that) and they have lifetime caps (perhaps 11 percent).

Mortgage resets: Record bill due.

One reason refinancing ARM borrowers chose fixed rates in higher numbers recently was because the interest-rate spread between an ARM and a fixed has become fairly narrow over the past couple of years.

According to Amy Crews Cutts, deputy chief economist for Freddie Mac, who was quoted in a press release, mortgage rates on 30-year fixed-rate loans averaged about 6.4 percent during the three months, while rates on 1-year Treasury-indexed ARMs were 5.5 percent.

That meant that although a borrower of a $200,000 loan would pay about $115 a month less with an ARM for the first year, the ARM could potentially cost $147 more than the fixed the second year, and rise higher every year until it hit the lifetime cap. Many borrowers prefer the certainty of knowing that their future payments will never be any higher than they are when they got the loan.

Fixed rates have gotten a little more expensive compared with the first three months of the year when even more borrowers -- 89 percent of one-year ARMs and 88 percent of hybrid ARMs -- chose fixed rates when they refinanced.

"The widening spread between fixed- and adjustable-rate mortgages in the second quarter made ARMs a bit more attractive than they had been," said Cutts.

Even though the interest rates on ARMs will almost always eventually surpass those of fixed rates, the ARM can still be attractive to borrowers. For people barely squeezing by, an ARM can be the difference between unaffordable and affordable.

Too, some buyers or refinancing owners have very short time horizons. People who aren't planning to stay more than two or three years in the home may wind up paying out less money with an ARM than with a fixed by the time they sell.

And borrowers who expect to have a lot more income in the future - perhaps one partner will enter the work force, for example - may want an ARM to make the present demands on income easier to handle.

Who can't get a mortgage now.

According to Cutts, fixed rates may become even more the loan of choice in the future. With lenders tightening lending standards and underwriting to the higher, fully indexed rates (the rates loans reset to after the initial low rates), demand for adjustable-rate loans should decline.