Painful ARM Twisting: Resets of adjustable mortgages will leave costly stretch marks

Market Watch ^ | 8/6/2006 | Chuck Jaffee

[ex-Texan]

BOSTON (MarketWatch) -- It is becoming increasingly obvious that financial advisers, real estate experts and parents will someday point to what is happening in the mortgage market today and use it as a cautionary tale of what can go wrong when a buyer stretches to get too much house during a market that seems invincible.

Real estate has been booming in most markets over the last five years or longer, fueled by interest rates that reached four-decade lows and by consumers who used new mortgage products to extend their buying power. Many home buyers stopped worrying about buying a home and instead worried about their ability to pay for one; rather than shopping for a deal that allowed for a lifetime purchase, they looked for a mortgage that allowed them to buy the most home for the lowest current payment.

So long as rates stayed low and housing prices continued to move up strongly, that strategy was a good one. And those things kept happening, so that homebuyers ignored the warnings issued by many mortgage experts about what would happen when times changed.

Well, times have changed.

The popularity of adjustable-rate mortgages means that nearly 25% of all outstanding U.S. mortgage debt is due for an interest-rate reset within the next two years, according to Economy.com, a Web site run by Moody's Corp. Some $400 billion in loans will get a new rate this year, and another $2 trillion are set to move in 2007.

Those moves won't be pretty. Just two years ago, the prime rate stood around 4%; today, it is more than twice that. As a result, payments on some ARMs will double too. The current forecasts from a number of experts have defaults on those loans increasing by 10%.

"There is no apples-to-apples comparison from the kind of mortgage someone could get a year ago and what they can get today," said Anthony Hsieh, president of LendingTree.com. "As rates rise on adjustables, there are steps people can take to reduce the sticker shock, but they're probably not going to be too happy with what they have to swallow now. ... They had a 42-year low in mortgage rates, but they were more concerned with how much they would have to pay each month than how much they could afford and buy a home reasonably."

Plenty of bad news

For someone who purchased a home using an ARM -- or taking advantage of some of the attractive teaser rates that were available over the last few years -- there is plenty of bad news if they need to refinance now. Obviously, that starts with current interest rates. Moving to a 30-year fixed-rate mortgage now means looking at rates north of 6.5%, and the longer a consumer waits, the bloodier that transition is likely to be.

But if the house was purchased recently -- and with the ARM keeping payments low -- there hasn't been much equity build-up; if the home is in a market that is now cooling down, the owner's equity is further impaired.

"People were gambling that their income would get to a point where it was high enough to pay for the home at some point," says Greg McBride, senior editor at Bankrate.com. "They also were gambling that the market would help them build enough equity that they could refinance if they needed to. Now they may need to, and those gambles aren't paying off."

Some of those consumers will become default statistics. Others will have to downsize, or change neighborhoods, in order to get a mortgage that is more affordable.

There's a problem with that "smaller house" strategy too, at least in markets where prices are on the decline. A homeowner who put little down and who built little equity -- and who lives in a market where prices are on the decline -- may find that a small step back is not sufficient to actually cut mortgage payments.

How bad is it?

McBride suggests that consumers who are facing adjustable-rate sticker shock should try to determine now just how bad the movement might be. From there, they can decide if it's time to make a change so that they don't get slammed.

Many adjustable-rate mortgages include annual and lifetime caps on the interest rate that can be charged, so homeowners may not see the full impact of sharply higher rates immediately. A 2-percentage-point annual cap is fairly common.

To see how bad an adjustment hit might be, consumers should look at their mortgage paperwork to see when the reset occurs, the rate that the mortgage is tied to and then the margin that is used for the adjustment.

The Libor rate, for example, has moved from roughly 4.2% a year ago to about 5.6% today. A mortgage that is pegged to Libor plus two percentage points, therefore, will adjust up to about 7.6%.

A homeowner looking at that kind of rate could refinance into an average fixed-rate deal and be better off. Says McBride: "There is still time to get off the tracks before the train gets closer, but people need to act now. A 7% mortgage today beats an 8% refi a few months from now.

"People's choices are only going to get uglier, and plenty of people are on their way to trouble. ... For everyone who has avoided this trouble, they're going to look back someday -- when their kids are looking for a mortgage and are tempted to stretch too far by using an ARM -- and have stories to tell about how they saw a time when everything that could go wrong with that strategy did go wrong."

Chuck Jaffe is a senior MarketWatch columnist. His work appears in dozens of U.S. newspapers.

[ex-Texan]

BS . . .

Nice try for using that misleading graph showing how dismal things are as "proof" of your point. That takes cajones!

[Neanderthal]

"We hit the trough with a 5.25% fixed .... but spinning the cylinder with one chamber filled (ARM) was never an option."

You didn't hit the trough. Our mortgage is 4.5 % fixed for 10 years incepting May 2004.

[SamAdams76]

That doesn't make sense. What do you gain by renting as opposed to owning?

[capitalist229]

In every crisis there is an opportunity. The last time this happened was in the 70s, peaking in 1980.

Buy gold. Wait for gold and interest rates to peak. Sell gold and buy 15% treasuries.

Fortunes were made in 1980 and they will be made again. 2009 ? 2014 ?.

The Fed perpetrates this cycle on the backs of the middle class.

This time could be the mother of all busts (MOAB) due to unprecedented debt levels.

Many are projecting hyperinflation instead of deflation this time around.

BUMP

[expat_panama]

...that misleading graph showing how dismal things are as "proof" of your point....

Sorry to catch you last night just before bedtime, maybe now we've all had a good night's sleep and our morning coffee it'll be easier.

Please bear with me; I'm obviously missing something. 

What I'm seeing is that over the past one and a half decades the average US household has gone from owing $30k on their $85k house, to now owing $65k on their $150k house.   I'm seeing how our bottom lines have improved by $30k (btw that's real dollars we're talking about here), but you're seeing something else that you're saying is "dismal".

Off hand, my take matches with the fact that mortgage foreclosures have been leveling down for years now. 

Only other possibility that makes sense is that you hate all lending and borrowing.  A lot of people oppose any loaning with interest.  Muslims do. Catholics did for centuries.  A lot of good Americans still take that position.  That's fine; it's just not my belief.

[Toby06]

>i?Bravo, you haven't had the ex-Tex kool-aid.

Scooping up my dogs crap is a more rewarding experience than reading ex-tex's fecal matter. At least the crap was useful dog food at one point.

[tx_eggman]

You didn't hit the trough. Our mortgage is 4.5 % fixed for 10 years incepting May 2004.

Yeah ... 10 year notes are typically .6% - .7% lower than a 30 year note ... I just couldn't gag down the extra $800/month in the short term. Then again, I'll be paying on mine while you're taking vacations in the Bahamas.

Still, all in all, we were happy we took the plunge when we did.

[expat_panama]

...ex-tex's fecal matter....

LOL! 

This morning I woke up to find that he'd dropped some on my desktop in post 41, I was just glad I'd spotted it in time and I hadn't tracked across the living room carpet...

[pfony1]

You said,

"RE has already gone down 20% in many parts of CA."

I gather that you are not aware that there is an important difference between "sales rate" and "sales price".

I hope this report, published by the C.A.R. will help clear that up for you:

"Tuesday, July 25, 2006

C.A.R. reports median price of a home in California at $575,800 in June, up 6.2 percent from year ago; sales decrease 26.3 percent..."

In other words, although the NUMBER of home sales in CA has declined, median home PRICES continue to rise.

IMHO, a person does not help his credibility by consistently getting his "facts" wrong.

[Diana in Wisconsin]

"Few people remember the late 1970s. At that time, I got a 10% mortgage loan only because it was a VA loan. I had friends with conventional mortgage loans that were as high as 14%."

I was a pre-teen then and Dad had just finished his apprenticeships and got his first Really Important Job, so we moved from inner-city Milwaukee where we rented to a home in the suburbs around Madison, WI. (Man, were we moving UP in life, LOL!)

I remember my folks very clearly sweating over interest rates at that time, and the price of gasoline if you could get it. My Grandpa saved the day and financed the home for them at a much more manageable rate of return. Dad did the same thing for me when I bought my first home at 25, and I'll do the same for our son when the time comes.

I've owned six homes so far, and have always made money on real estate, either rental units or single-family homes. If you want to make money in real estate, the trick is to buy no more than you can afford to lose. :)

And stay OUT of the coastal markets; there is plenty of affordable real estate in The Heartland. It ain't Rocket Science. ;)

[expat_panama]

...stay OUT of the coastal markets; there is plenty of affordable real estate in The Heartland. It ain't Rocket Science. ;)

There's nothing like opening one's eyes when it comes to getting a better handle on reality      Not only does it give life a happier outlook, it's also a heck of a lot easier on the old 'gastro-intestinal' (if you get my drift). 

We are blessed to live in good times with low interest rates.   Doomers who point out this uptick that we've been having for the past few years, were also crying during the upticks in '88, '95, and '00.   Previous upticks eventually led to new lows, but I say that all this tells us nothing about future interest trends.  On the other hand, it's possible that all those tears might shed some light on why sea levels have been rising...

[ex-Texan]

It is not just the U.S. The housing bubble is world wide and the effects of the BIG crash will be felt all over the world. Take a look at skyrocketing foreclosures in Britain:

Repossessions, mortgage arrears and bankruptcies have all rocketed over the last year.

The number who risk losing their home has returned to levels not seen since the dark days of the early 1990s. * * * In the first six months (of 2006), one person was made insolvent every minute by the courts in England and Wales.

Yesterday's alarming official figures show how the culture of 'easy credit' and 'spend, not save' has begun to take its toll.

The number forced out of their homes soared by 76 per cent over the last year * * *

Take Your Head Out of the Sand

How could anybody who professes to live in Panama know what is really happening in America? How long have you lived outside the U.S.? Your original graphic is from 2000. It is over six years old! Why should people believe a guy who posts outdated news reports and outdated statistics to 'prove' his points? Moreover, your most recent graphic clearly shows foreclosures in 2005 rising above levels in the 1990's. Back then, thousands of people found themselves upside down in real estate. Especially hard hits were owners of commercial properties in downtown Los Angeles. You are the one who is cherry picking news reports. Not me. Yadda Yadda