Expensive ARMs: An Answer

On Friday I asked why ARMs were so expensive. I got a few responses, but the best was from an anonymous commenter on Seeking Alpha, "User 122506". His or her comment is worth quoting in full:

It seems the lending markets have a reduced appetite ARMs right now, with rates (@3-5 yr) within 1/4% or so of a 30 yr fixed rather than a more "normal" 0.75-0.875% below the fixed. The more "normal" pricing would reflect the lower cost of funding the ARM off the nearer term yield curve (for say 3-5 year ARMS) versus the longer term cost of the 10 year Treasury (off of which 30 yr mortgages are priced).
Nomenclature point of order: Properly speaking, those rates you quote aren't "teaser" rates; teasers are significantly lower rates for a short period of time (like a 1% or 2% rate for the first 3 or 6 months) which then reset to the fully indexed rate, or to an initial fixed rate for some additional interim period. The rates you list are plain old "hybrid ARM" or "initial fixed rate converting to floating" ARM rates.
Your friend should stay away LIBOR based ARMs. Most of the time, the typical pricing (LIBOR+225bp vs. 1-yr Treas+275) is very close to the same rate when you hit the adjustment. But about once or twice a decade when credit markets blow up (like recently) the spread of LIBOR-to-Treasury widens substantially, and if your adjustment happens to occur during such a period you can pay quite a bit more than if you were tied to the Treasury. (Also, now that I look at it I think that is what is wrong with your table, which I didn't quite understand; after a return to "normalcy" at some point that 323 will pull in closer to 275).

The short answer, then, is that ARMs aren't normally as expensive as this – that right now we're going through a bit of an aberration. This makes a certain amount of sense, given that default rates on ARMs are, for various reasons, significantly higher than default rates on fixed-rate loans. Of course, that doesn't mean that any given individual is more likely to default if they get an ARM as opposed to a fixed-rate loan, but that doesn't matter: if you're shopping for a mortgage today, you should get a fixed-rate loan in any event, not an ARM.

Now, will there come a point when ARMs become attractive again? I don't know – that standard floating rate of Treasury + 275bp still looks expensive to me. But they will surely become more attractive than they are now.