A high percentage of borrowers with adjustable-rate mortgage are choosing to refinance to safer, fixed-rate loans.

In the classic science fiction film, Voyage to the Bottom of the Sea, an uncontrollable atmospheric fire threatens all life on Earth. As the end nears, a well-directed submarine missile puts out the fire and saves the day. Unfortunately, the stifling problems in today's mortgage industry can't be remedied in just one shot. Borrowers who find themselves in too deep aren't waiting around-they're finding shelter in fixed-rate mortgages (FRMs).

According to Freddie Mac's Refinance Product Transition Report, a high percentage of adjustable-rate borrowers refinanced to fixed-rate programs in the second quarter of 2007. Specifically, 85 percent of 1-year ARM borrowers refinanced into FRMs, as did 86 percent of hybrid ARM borrowers. While the numbers are high, they're actually down slightly from the first quarter figures of 89 percent for 1-year ARMs and 88 percent for hybrids. The change is likely due to a small uptick in average fixed rates.

The wave of ARM popularity

ARMs have been popular with buyers on a tight budget, because the initial payment is lower. For the second quarter of 2007, for example, Freddie Mac calculated the average rate for a 30-year, FRM to be 6.4 percent. This compares to a 5.5 percent average rate for a 1-year, Treasury-indexed ARM. For every $100,000 of debt, this 0.9 percentage point interest rate variation means a $58 difference in the first year's monthly payment.

The trade-off for those early savings is the probability that the ARM's interest rate will go up and eventually exceed fixed-rate levels. Some ARM rates can increase by as much as 6 percent over the life of the loan. It's a risk many buyers chose to accept, hoping to refinance in the future. In all too many cases, however, that planned mortgage refinance didn't happen. The result? Borrowers fell into default when their payments started to rise.

Those rising default rates have, in part, ushered in some sweeping changes in the mortgage industry. Lenders are far more cautious in funding ARMs. Most of them are now checking the borrower's income qualifications against the rate the loan will carry after the low teaser rate expires. The former practice was to qualify the buyer for the low teaser rate only. Now, homebuyers and owners are more aware of the inherent risks of ARMs. Where they were once viewed as a shortcut to the American Dream, they're now more commonly thought of as a potential nightmare.

All the attention given to rising default rates and the volatility of ARMs may be why many borrowers are switching over to FRMs. Or perhaps it's just the comfort of knowing that the interest rate and payment won't change, ever. Whatever the reason, experts expect the trend to continue. Putting out the fires in the mortgage industry won't happen overnight, but with more borrowers refinancing into safer programs, it will happen eventually.

Published on October 18, 2007