For mortgage borrowers, it's not 2004 all over again.

In the Treasury market, interest rates are starting to look normal again. Short-term rates are extremely low, thanks to market turbulence and the Federal Reserve's multiple rate cuts. As you look at longer-term Treasuries, rates rise somewhat for those willing to commit their money for longer periods. This so-called normal yield curve makes sense intuitively -- you get paid more for the risk of locking up your cash at relatively low rates.

Under normal circumstances, the mortgage market behaves in much the same way -- especially when short-term rates are low. But at least for now, adjustable-rate mortgage rates haven't behaved the way you'd expect -- and that's bad news both for borrowers and for policymakers trying to restore stability to the financial system.

Where's my 3%?
The last time short-term rates were this low, adjustable-rate mortgages gave borrowers an opportunity that many couldn't refuse. According to Bankrate, in early 2004, you could get a one-year ARM below 3%. Now, with the federal funds rate at 2.25% and three-month Treasury yields at 0.6%, one-year ARMs are still hovering above 5%.

As you can see from some current rates from major institutions, it's clear that relatively high rates persist for ARMs across the country.


APR on
5-Year ARM

Wells Fargo (NYSE: WFC)


Bank of America (NYSE: BAC)


Fifth Third Bancorp (Nasdaq: FITB)


SunTrust (NYSE: STI)


Citigroup (NYSE: C)


In addition, while the listed APR is based on current low-interest rates, what used to be called the "teaser rate" -- the rate that applies during the initial five-year period -- is actually higher. Wells Fargo's initial rate is 7%. Citi's is 6.75%.

Higher risk, higher spreads
One reason adjustable-rate mortgage rates haven't dropped is because lenders are more risk-averse than ever. Falling home prices are already sapping liquidity from mortgage-lending institutions, requiring cash infusions at Countrywide Financial (NYSE: CFC) and other mortgage lenders.

In addition, lenders are understandably reluctant to offer adjustable-rate mortgages. With the threat of federal legislation freezing rates at artificially low levels, borrower financing through ARMs is an extremely risky proposition. Furthermore, because the market for mortgage-backed securities has experienced severe problems lately, lenders have to plan for the possibility that any loan they make will have to remain on their books for the long term.

In response to this additional risk, lenders are demanding higher spreads over prevailing Treasury rates. As a result, borrowers may see less benefit from lower rates than they have during similar periods of low rates in the past.

Whether the mortgage market will start to function normally again remains to be seen. For now, however, most borrowers still have every incentive to choose fixed-rate mortgages over ARMs.

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Fool contributor Dan Caplinger is sticking with his fixed mortgage. He doesn't own shares of any companies mentioned in this article. The Fool's disclosure policy never stops working for you.