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According to Harvard University’s Joint Center for Housing Studies’ recent report “The State of the Nation’s Housing,” more than one in eight borrowers spends approximately 50 percent of his/her income on housing. In fact, the study reports that the number of those households jumped by 2.5 million from 2000 to 2003. These facts, plus the increase of interest-only and hybrid-ARM loans, are fueling concerns of a bubble burst — specifically in hot housing markets such as California and Florida. Analysts also have speculated about an economic slowdown, pointing to the decline in long-term interest rates. Typically, when the Fed raises short-term rates, the long-term rates follow suit. Today, though, long-term rates are still declining, which could trigger a new surge in refinancing.
In some cases, these new refinances come from borrowers who are using the interest-only and hybrid ARMs to lower payments and free up cash for other investment purposes. For these borrowers, the ARM options work well, as the borrower can handle the jump in payments when the interest rate fluctuates. The concern is for those who are purchasing homes they could not afford if interest rates were not so low.
Comparing both options
To better illustrate this, let us consider an example of a California borrower choosing between an option ARM and an interest-only, 5/1 hybrid ARM. We will assume the property value is $500,000 — nearly the median home price in the state — with a total loan amount of $400,000. The monthly U.S. Treasury average (MTA) remains steady at 2.5 percent, housing appreciation stays flat and the 5/1 hybrid is originated at 5.25 percent. Collateral specifications of the pool are a one-month teaser rate at 1.375 percent, with the margin being 2.95 more than the MTA. The borrower’s FICO score in this case is 715 or more, and the loan is 80-percent loan to value (LTV) with no prepayment penalties.
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