Keep Eyes on Your Variable-Rate Mortgage

July 15, 2006

Keep Eyes Fixed on Your Variable-Rate Mortgage

By DAMON DARLIN

The raising of interest rates on millions of adjustable rate mortgages over the next several years has all the makings of a classic horror story.

As home prices appreciated from ridiculously high to unbelievably higher, more Americans began using mortgages that allowed them to buy more house for less of a monthly payment. Next year, a large portion of those rates move up and homeowners who opted for the exotic mortgages could find their payments doubled. Talk about bloody. They need to find a way to minimize the pain.

Many will refinance their loans. But for others, whose mortgages now exceed the value of their homes or whose debt payments exceed 40 percent of their incomes, there may be no other solution than to get out of their houses. With the housing market cooling, selling it may not be easy. Some may default on their loans.

With more homes on the market, prices could begin to fall. That reduces home equity — the difference between the amount borrowed and the total value of the home — and could force people whose loans change in 2008 and 2009 to consider selling, further accelerating the drop in prices. Some of those cities with the highest proportions of interest-only loans are also at the greatest risk of falling prices.

Mortgage lenders, however, say they are not worried. Economists say even the worst-case outcome will not have much impact on the overall national economy. Christopher L. Cagan, director of research and analytics at First American Real Estate Solutions, points out that mortgage industry losses of $110 billion spread over several years would amount to a mere 1 percent of the total national homeowners’ equity of $11 trillion and a hiccup in the gross domestic product.

On a personal level, however, there is going to be pain as homeowners struggle to make higher payments. In 2003, of all new mortgages, 10.2 percent were interest-only, meaning the homeowner paid only the interest for the initial period of the loan. According to Loan Performance, a research firm, 26.7 percent of all loans were interest-only last year and another 15.3 percent were payment-option adjustable rate mortgages, which allow homeowners to choose how much they paid each month.

In some areas of the country where homes are expensive, these loans were highly popular. In most California cities, as well as in Denver, Washington, Phoenix and Seattle, interest-only loans represented 40 percent or more of all mortgages issued in 2005.

Traditionally, interest-only loans and adjustable-rate loans were used by people who expected to live in a house only a short time, but such loans have turned into “affordability products” as housing prices rose. The interest rate on the loans, while below that of conventional 30-year fixed-rate mortgages at the beginning, resets after 3, 5, 7 or 10 years, depending on the loan. So, homeowners who took out loans in 2004 could find, for example, that their initial 4.25 percent loan climbs to 6.25 percent or 7.25 percent next year.

Someone now paying $350 a month for a $100,000 interest-only loan could be facing payments of $680 both because of the shift to the higher rate and because the borrower would have to start paying off the principal as well as the interest.

“You need a couple of good pay raises in order to afford it,” said Mark Fleming, chief economist with CoreLogic, which develops risk models for the mortgage lenders. “It’s pretty hard to deal with a payment shock of 80 percent or 90 percent,” he said.

The mortgage industry is not worried about payment shock. Why?
“It offers an opportunity,” said Brad Brunts, managing director of portfolio management at Citi Mortgage, a unit of Citigroup.

He, like others in the mortgage industry, sees the higher payments as a boost to the flagging mortgage refinancing business. Lenders will adjust about $500 billion in mortgages this year and $700 billion next year, according to Freddie Mac, the quasi-government agency that repackages mortgages for investors. Expect to find the mailbox stuffed with refinancing offers.
Mr. Brunts said only a minority of mortgage holders will face real problems. Most will successfully refinance and though they will pay more, he thinks they will be able to make the payments.

Anyone with a rate that will increase in the next few years, however, ought to worry. If homeowners have an adjustable-rate mortgage, they can hope or pray that there is a recession severe enough for the Federal Reserve Board to lower interest rates. But they would also have to hope or pray that the recession was not so severe that they lost their jobs.
Hoping or praying is not a useful financial strategy, if only because most economists think that rates will climb a bit more and then stay steady through 2007. No one can say with any certainty whether rates will rise or fall in 2008 or 2009.

Here is more practical advice. First, homeowners should take a look at their loan documents to determine when it changes and by how much. In most cases, the rate cannot go up more than two or three percentage points a year.

That is still a lot. The next thing for an owner to do is take a deep breath and figure out what the monthly payments will be when the rate moves. Any number of mortgage payment calculators on the Web can help. Hard as this may be to face, homeowners should not ignore it. Those who get behind on payments can ruin their credit ratings and then it will be even more difficult to refinance the loan at a reasonable rate.

“It all depends on the ability to refinance before the interest rate resets,” said Suzanne Mistretta, senior director of Fitch Residential Mortgage, which analyzes credit risk of mortgages. “Most of them will get out. Hopefully, they will get out,” she said. “That is the big question.”

Mortgage delinquencies and foreclosures are still low nationwide and in the coastal states where prices appreciated the most. In the last year, the highest portions of homeowners who fell behind in payments were found in regions where homes were least expensive like the South and the Rust Belt states. But lenders expect the numbers will go up across the country even if they never hit crisis levels.

In most cases, homeowners will probably want to refinance the loan because the rate on a new loan will be lower than the reset rate. The best option may be a fixed-rate mortgage. In contrast to three years ago, the difference between interest rates on fixed-rate and adjustable mortgages has shrunk.

Rates vary by the amount borrowed and where the house is, but a 30-year fixed-rate mortgage was averaging 6.74 percent this week, while an adjustable-rate loan that will not change for another five years was 6.33 percent. The initial, or “teaser” rate for a new five-year interest-only loan was advertised as 5.5 percent to 7 percent.

Lenders never cease to be creative. They keep coming up with new flavors of loans: 40-year fixed-rate loans that offer lower payments, but that cost more over the long run, or 30-year interest-only loans in which only interest is paid for the first 10 years. The only way to know which one to choose is to make the lender calculate the payments for every option.
Homeowners should start exploring the refinancing options about six months before a loan changes. Lenders say there is little reason to do it earlier. Payments are lower with the interest-only loan and, presumably, those holding the loans are saving the difference. At this point, if rates stay about the same or do not go much higher, there is little advantage to acting too far in advance because the payments will just go up sooner rather than later. (But homeowners should spend less elsewhere right now. They may as well get used to the drill; they will need the savings to cover the future higher payments.)

Sometimes, though, homeowners may have to take more drastic steps. The lender may not be interested in refinancing a home loan when the value of the home is below the loan amount. That could happen because a homeowner took out all the equity in a previous refinancing. (Freddie Mac estimates that Americans took $556 billion out of their homes through cash-out refinancings and home equity loans since 2004.)

It could happen if the price of the house has fallen or if the owner has been making only the minimum payment on a payment-option loan so that the loan balance has actually grown. (It is what the industry calls a negative-amortization loan). The best option then is probably to sell the house and scale back. Homeowners may also want to sell if they can clearly see that there is no way they can make the higher, refinanced payment.

In that case, it is better to act now before a few million other interest-only mortgage holders dump their homes on the market.