Housing Bulletin—Beyond ARMs’ Length

In the midst of all the recent fretting over subprime mortgage failures, some real-estate analysts have been warning of another wave of mortgage trouble on its way: the massive reset of Adjustable Rate Mortgages (ARMs) to higher rates than what prevailed when the loans were made three to five years ago. According to many industry observers, the new, higher payments on those loans could force another round of borrowers out of their homes.

People who used lower-cost ARMs to buy more house than they would otherwise have been able to afford may have been counting on their own income going up before the inevitable reset to a higher rate. Or they might…

In the midst of all the recent fretting over subprime mortgage failures, some real-estate analysts have been warning of another wave of mortgage trouble on its way: the massive reset of Adjustable Rate Mortgages (ARMs) to higher rates than what prevailed when the loans were made three to five years ago. According to many industry observers, the new, higher payments on those loans could force another round of borrowers out of their homes.

People who used lower-cost ARMs to buy more house than they would otherwise have been able to afford may have been counting on their own income going up before the inevitable reset to a higher rate. Or they might have gambled that interest rates would stay low, allowing them to refinance later into another easy payment. Either way, it’s time to pay the piper—and various economists estimate that at least $1 trillion in low-interest ARMS, mostly 5-year loans made in 2002 and 2003, are due to reset this year and next.

How hard will a reset hit? Some borrowers who took out loans at the lowest level reached by interest rates could see their loan payments increase by as much as 53 percent. (That refers only to the part of the mortgage payment that covers the home loan itself; property taxes, insurance costs, and other fees increase independently of a loan reset.) Unless their income has shot up in five years, those mortgagees could find that the dramatic spike in house payments will gut-punch the family budget.

Ray Cohen, a mortgage broker at the Chicago-based Revere Mortgage www.reveremortgage.com pegs the low point of interest rates at June 3, 2003, when a 30-year fixed-rate loan was at 5.125 percent and a five-year ARM was at 4 percent. Jumbo loans—those exceeding $417,000—were subject to slightly higher interest rates, but the spread between an ARM and a fixed-rate loan was about the same. The differential meant that borrowers could cut 21 percent out of their housing payments by going with an ARM—as legions of borrowers did. (Right around that time, I took out an even lower-cost loan through a different broker, a three-year ARM with a rate of 3.125 percent.)

Because of the complexities of the credit markets, five-year ARMS now have higher interest rates than 30-year fixed (in the non-jumbo sector), so anyone resetting will most likely opt for a 30-year fixed-rate loan—especially with little expectation of another interest rate dip comparable to that experienced four or five years ago. Cohen says the going rate for a 30-year loan on October 3rd was 6.125 percent; the increase from a 4 percent ARM to a 6.125 percent fixed loan is more than half—about 53 percent.

In the jumbo market, ARMs are still cheaper than 30-year loans. But even for those borrowers, the jump from a 2003 loan at 4.25 percent to a 2007 loan at 6.5 percent means jumbo loan payments will also increase by 53 percent. Of course, the jumbo borrower is a little more likely to have investments or other financial resources to cushion the blow of a rising house payment. The middle-income borrowers who stretched to cover a low-cost payment on a $300,000 house—the ones that the Christian Science Monitor called “the Wal-Mart shopper, not the Tiffany shopper”—are the borrowers more likely to risk losing their homes when an ARM reset puts the monthly cost of the house well out of reach.

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