Fed could ease ARM reset pain

NEW YORK (CNNMoney.com) -- If the Federal Reserve cuts interest rates Tuesday as expected, borrowers with mortgages that are about to reset to higher levels will get a break.

Many adjustable rate mortgages are tied to one-year Treasurys, which tend to follow in the same direction as the Fed Funds rate.

"The new rate will be more affordable," said Allen Hardester, a mortgage consultant in Maryland.

The number of adjustable rate mortgages (ARMs) up for reset is forecasted to peak this fall, with an estimated $50 billion worth poised to adjust in October.

Holders of ARMs have already gotten a reprieve. Fixed-income investors, seeking safety, have pushed up short-term bond prices and brought down short-term yields.

From a recent high of 5.02 percent in mid-July, one-year Treasury yields have fallen to 4.23 percent as of Sept. 17. The reset rates of ARMs are calculated using an average of several Treasury prices, but the final result should be around that 4.23 percent, plus a few additional percentage points, which is the margin set by the lender.

With a typical margin of 2.75 percentage points, someone with an ARM resetting might pay an interest rate of 6.98 percent, compared with 7.77 a month earlier.

On a $200,000 mortgage, borrowers would be paying more than $100 less a month than they would at 7.77 percent. For borderline borrowers, that could be the difference between being able to make the mortgage payments or not.

The yields on short-term Treasury bills tend to follow the same direction as the Fed Funds rate, so ARM reset rates could drop even further into affordable territory.

Said Keith Gumbinger, of the mortgage information publisher HSH Associates, "If you're coming due for an adjustment - I don't want to say you're in for a jackpot - but it could help some on-the-cusp borrowers."

But Richard DeKaser, chief economist for National City Corp., warned that if the Fed lowers rates by only a quarter point, versus half a point, Treasury bill yields may not move much. "That [quarter point drop] expectation has already been priced into short-term Treasurys," he said.

Not all resetting ARM borrowers will benefit from T-bill yield declines. Many 2/28 hybrid ARM borrowers started their mortgages at such low "teaser" levels that their rates will rise the contractual maximum of three percentage points even if yields do remain low, according to DeKaser.

And one large class of ARM borrowers - as many as half, according to Gumbinger - may not get a break because their loans are tied to LIBOR, the London Interbank Offered Rate. And those rates have been rising: Short-term LIBOR rates are above 5.5 percent, versus 5.33 percent 30 days earlier.

But the loan resets based on T-bills will certainly be reasonable compared with historical averages if yields remain low or fall further. At 6.84 percent they're not much higher than the current rate for a 30-year fixed, which averaged 6.31 percent last week, according to Freddie Mac.

"It does take some of the pressure off," said Gumbinger. "Maybe the borrower could now wait for a better deal [before refinancing]."