Why Are ARMs So Expensive?

A friend of mine is shopping for a mortgage right now, and I just had a very frustrating conversation with her mortgage broker. What I'd like to do is be able to choose between a fixed-rate mortgage and an adjustable-rate mortgage. If I take the adjustable-rate mortgage, I expect to pay a lower interest rate in return for taking on interest-rate risk. But it seems that the only ARMs on offer are all "teaser rate" products, where the mortgage resets to a significantly higher spread once the initial teaser period is over. And even the teaser rates, on closer examination, don't look particularly attractive compared to the fixed-rate mortgage on offer.

The broker offered three ARMs to my friend: a 7/1 ARM at 6%, a 5/1 ARM at 5.875%, and (after I asked about it specifically) a 1/1 ARM at 5.75%. All three of them, he said, reset to 225bp over one-year Libor at the end of the initial period.

The reason I asked about the 1/1 ARM, of course, was to get an idea of what happens to the spread over Libor. At the moment, 1-year Libor is 4.47%, which means that the 1/1 ARM starts off for the first year at 128bp over Libor, and then jumps all the way up to 225bp over thereafter. If one-year interest rates stay where they are, that means my friend will be paying interest of 6.72%. Even the 30-year fixed-rate mortgage is much lower than that: just 6.125%. And of course my friend would be paying well over 7% once one-year rates go above 4.75%, which is entirely possible.

The broker was quite clear that you should never buy an adjustable-rate mortgage with an intial rate any longer than the amount of time you intend to own your home. If you're going to sell within five years, then get the 5/1 ARM: it's cheap money. But if you're intending to stay in your house and pay off the mortgage over time, then don't even think about it: you'll be killed once that adjustable rate of 225bp over Libor kicks in.

Libor doesn't go out beyond one year, but Treasury rates do; the one-year Treasury trades today at 3.49%. So let's look at spreads over Treasuries as opposed to spreads over Libor: that way we can compare all the options on a like-for-like basis. And let's assume that 225bp over one-year Libor is the same as 323bp over Treasuries.

This is just incredibly counterintuitive to me: the spread curve on mortgages seems to be pretty steeply inverted. The more-floating and less-fixed the mortgage, the higher the spread is – even before you take into account the seemingly-penal interest rate once the initial period is over. Are these numbers remotely similar to the ones that Alan Greenspan looked at when he famously said that adjustable-rate mortgages made more sense than fixed-rate mortgages? How can it make sense for adjustable-rate mortgages to reset to 323bp over Treasuries, while a 30-year fixed-rate mortgage for the same borrower is quoted at 158.5bp over Treasuries?

Indeed, looking at this table, even the initial rates offered on the ARMs look pretty underwhelming: they're "teaser rates" only in comparison to the really high rate charged after they reset. If anybody can provide an explanation of what's going on here, I would be extremely grateful, because I can't make heads nor tails of it. Why is it that a borrower pays more when the borrower is taking interest-rate risk than when the lender takes interest-rate risk?

Update: The fixed interest rate on a 15-year fixed rate mortgage is 5.875% – the same as the teaser rate on the 5/1 ARM.