Gina Pogol

If you took out an adjustable rate mortgage (ARM) in recent years, chances are your rate may be subject to a reset in 2007. The Mortgage Bankers Association estimates that $1 trillion worth of adjustable rate mortgages will reset by the end of 2007. With an average loan amount of about $300,000, approximately three million homeowners could be facing a rate revision this year. While these homeowners may have different kinds of ARMs, they all share one characteristic: after an initial period with a low start rate, their loans will adjust to a rate linked to a financial index, such as the one-year T-bill, Cost of Funds Index (COFI), or London Interbank Offered Rate (LIBOR).

Where your loan is headed this year depends on the index it's tied to and the margin (usually between 2 and 5 percent above the index) that your lender charges. Most borrowers with loans resetting in 2007 will be making higher payments by year end. For example, the Financial Forecast Center predicts an increase of 0.35% in the one-year Treasury securities yield to 5.3% by April 2007. If your loan is based on the one-year T-Bill and has a 2 point margin, you can expect to pay approximately 7.3% on your fully-indexed, or adjusted, loan.

Fixed vs. Adjustable Mortgages
The primary difference between fixed and adjustable rate mortgages is that while ARM payments change over time, fixed rate mortgage rates and payments stay the same over the life of the loan. No matter what happens in the financial markets, your rate remains fixed. This predictability is the main selling point for fixed rate mortgages. The reason that lenders charge a higher rate for a fixed mortgage is that by fixing your rate, the lender risks losing money on your loan if market rates increase. This is called interest rate risk. Lenders can charge a lower start rate on adjustable rate mortgages because ARMs are subject to periodic adjustments or resets. This offloads some of the interest rate risk from the lender onto the borrower. Your lender is willing to charge you a lower start rate because if rates increase your rate will also. By adding a margin to the index, your lender builds a profit into your loan even if rates increase

ARM Pricing and Geography
Unlike most fixed rate mortgages, ARMs can be priced differently depending on the location of the property. For example, one of the nation's largest banks charges Californians a rate that is 0.375% higher than the rate that borrowers in the Midwest pay for the same 3/1 hybrid ARM. Because many ARMs are portfolio products serviced by the lenders and not sold through Fannie Mae or Freddie Mac, pricing may not be nationally standardized. In addition, portfolio lenders try to minimize their risks by spreading their lending over large geographic areas. A lender may charge more in areas considered riskier, i.e., prone to natural or economic disasters, or in areas where it already has more exposure than it is comfortable with. Conversely, a lender trying to increase its portfolio in a given geographic area could drop its rates on many loans until it achieves greater balance in its portfolio. With a wide variation in rates and so much information available online, it is important to shop for your adjustable rate mortgage. One lender's high-rate area may be another's bargain-priced locale.

In the Beginning??.ARM Teaser Rates
ARMs were so popular in recent years because the low start rate (also called a teaser) enabled borrowers to afford rapidly escalating home prices by lowering payments and thereby increasing buying power. Although lenders typically qualify you at a rate higher than the teaser, it is still usually lower than the prevailing fixed rates. This may enable you to buy a home for which you couldn't qualify under a fixed rate program.

Some buyers opt for fixed payment ARMs, also called option ARMs or negative amortization ARMs, with start rates as low as 1%. The difference between the minimum payment on a $300,000 loan for an option ARM at 1% and the fixed rate payment at 6.5% is dramatic--nearly $1,000 a month! These loans can be appropriate for borrowers who use the equity in their homes to keep payments low for a limited time, but expect a substantial income increase. For example, a medical school grad who knows she will be making enough to afford her home in the near future might be one good candidate for this type of loan package.

ARMs and Affordability
The amount of sticker shock you encounter when your loan resets depends on a number of factors. If you have a T-Bill-based ARM loan with an initial rate at 4% and your rate resets in 2007, your fully indexed rate would be about 7.3%. However, most ARMs feature a periodic rate cap of 2%. So the highest your rate could go would be 6%. Even so, the increase is substantial: The monthly payment on a $300,000 mortgage would go from about $1,432 at 4% to approximately $1,799 at 6%.

The borrowers who may be pushed over the edge are those who needed the low teaser rate to afford their homes, and counted on increasing real estate values and continuing low rates to make home ownership feasible. While typical underwriting guidelines require that borrowers qualify at a rate 2 points above the teaser rate, or at the current fully-indexed rate, lifetime caps on rates are often 6 points higher than the start rates. Borrowers who barely qualified at 2 percent above their start rates may find themselves saddled with loan payments they can't possibly afford.

Borrowers who took out loans with payments starting at 1% may end up even worse off. Many homeowners used these loans to purchase more house than they could afford with a conventional fully-amortized loan. For example, a homeowner would make nearly the same monthly payment on a $550,000 loan based on a 1% rate that he or she would on a $300,000 loan fixed at 6%--about $1,800. The problem is the 1% isn't the actual interest rate; it's just the payment amount. The actual rate is calculated like all ARMs, using an index and a margin. If the fully indexed rate goes to 7.3%, the actual payment on that $550,000 loan blows up to nearly $3,800! So, the borrower is paying $1,800, but owes $3,800--and that $2000 difference each month is added to the loan principal. This is called negative amortization. This scenario obviously can't continue forever, or the loan would never be repaid. The lender adjusts the minimum payment up over time and may also recalculate the loan payments based on the new, higher balance of the loan. This is called re-amortizing the loan. The result is the borrower's rate, payment, and balance all increase.

The Bottom Line
ARMs have an upside and a downside. When taken out for the right reasons and in the right situations, they can be part of a savvy investment strategy and a good option for purchasing or refinancing your home. It's important for homeowners to assess their financial positions, predict their income stability, and determine their tolerance for risk. For those who can't weather a huge payment increase, fixing their rate and payment while 30-year rates are relatively low may be the most sensible option.

Sources:

Federal Reserve Board

First American Real Estate Solutions

Mortgage Bankers Association

CNNMoney

Risk Glossary

 

About the Author
Gina Pogol writes for an online media company. She holds a Bachelor of Science in Financial Management and was formerly a loan consultant with Centex and business credit consultant with Experian.

Note: All projected percentages and payment amounts on rates are estimates and may change depending on market forces and your particular financial situation. For the most accurate information, please consult your licensed lender or broker.