A Call to ARMs

There is an inescapable iceberg on the horizon, the coming date when millions of homeowners who have ARMs of one kind or another are going to face payment shock. 3/1 or 5/1 or 7/1 ARMs done during period of low interest rates are going to adjust from the current rate, say 4% or 5% to index plus margin. That means a big payment increase for all of them.

Now the press is full of stories about this. Some say that it will cause a massive increase in the number of foreclosures. Others say it won't be bad at all. One estimate courtesy of researchers at First American Real Estate Solutions is that 1% of recent originations would be affected. It is important to understand, however, that the normal foreclosure rate hovers just over 1% so if another 1% went into foreclosure, that would almost double the rate, and that would create some repercussions in the mortgage industry. Let's first look at how this might affect a homeowner.

Most such ARMs are tied to 1 year T-Bill rates. The T-Bill rate is currently 4.31. Add the typical margin of 2.75 and you get 7.05%, which, in accordance with the terms of some loans will be adjusted up to the next multiple of .125. That means the rate would go up to 7.125%. Now what does this mean in terms of payment?

Let's say someone got a $200,000 loan a few years ago at 4.5%. The initial payment on that loan would have been $1013.37. Now, after 5 years, the loan would have been paid down to $182,315. At a new interest rate of 7.125% amortized over the remaining 25 years, the new payment would be $1,303.14, a 29% increase over the initial payment.

Now there are a number of classes of people who have such loans. Some people may plan on selling their homes before then or plan to be in their homes for another year or so. They will only have to make the payment for a short period. Others easily qualified for the lower payment and won't have any trouble handling the increased payment. Others will have had increased income over that period and will be able to handle the higher payment.

Others, who plan on staying in their homes, will see the writing on the wall and will have refinanced into a rate lower than 7.125% by then. Even if the initial loan had been for 90% or 95%, their homes will have appreciated enough to allow them to refinance into a lower rate loan. Still others will see that they will be in trouble payment-wise, have enough equity to bail out with some still intact, and will sell their homes.

The ones who are between a rock and a hard place are those who had little equity in the first place, have not had much appreciation, and are not earning more money to pay the increased payment. If they do not make the payments, they will be faced with foreclosure. They can come to some kind of understanding with the lender, sign a Deed in Lieu of Foreclosure, move out and send them the keys. Failing that, there are some who will try to live in the house rent free until the lender finally forces eviction.

Whatever people's situation, this should be a wake up call to do something about finding a long-term solution now if they are going to continue to be in the home. I will also admit that one of the hardest things as a lender is to get people to refinance when the interest rate is actually going to increase. If they have a 4.5% rate now and the new rate is, say, 6%, they are obviously looking at an immediate increase in payment even though it is a lot less than 7.125%. It's hard for some people to endure some short term pain even if it means higher loan term gain.

Many people just engage in wishful thinking, hoping that rates are still about the same next year when the chickens finally come home to roost. Personally, I think that is a little silly have your family's financial future depend upon wishful thinking. But some people, by virtue of a strong financial position, are able to take some risks that would be imprudent for the family next door. What is important is that each family looks at the opportunities and risks today and makes an intelligent decision based upon a careful examination of those factors.

To summarize, when I look at all of these possibilities, I don't think that the consequences are going to be all that great. That said, there are two other classes of ARMs out there that pose more significant risks to individual homeowners and the mortgage industry. Those are the interest-only loans and the negative amortization loans. There have been huge numbers of these loans originated in the past couple of years, as many as 40% of all the loans in some markets, and these pose far greater danger. I'll talk about that risk in the near future.

Stay tuned.