Coming Home to Roost : County Families See Adjustable-Rate Mortgages as Mixed Blessings
Bill and Floy Hotarek expect to make a higher payment next month on the adjustable-rate mortgage they chose to buy their Laguna Niguel condominium five months ago. Though both work, they’re already cutting back on nights out at restaurants and the movies.
Tammy Wilson and Richard Slaten were in no hurry to get married when they bought their Laguna Hills home four years ago. Now, with another increase in their adjustable loan payment, they can’t afford the kind of wedding they want.
Tom and Paulette Fletcher wanted no part of the fluctuating rates that worry home buyers who have adjustable mortgages. They decided to pay the heftier monthly payment that came with the fixed-rate loan they took out to finance their Anaheim home.
“This way, we hope our income will go up, and we’ll be able to put the big payment behind us,” Tom Fletcher said.
Fletcher’s reasoning--the classic rationale that has stood generations of home buyers in good stead--seems wise now that interest rates have begun climbing again.
A Struggle to Adjust
But for those with adjustable-rate mortgages, or ARMs, the struggle can go on for years.
“There’s a bunch of people--maybe 20% of all home owners have ARMs now--who have set up a decreasing quality of life,” said Walter P. Blass, president of Shearson Lehman Hutton Mortgage Co. in Newport Beach, one of the nation’s major home lenders.
And it’s not just adjustable mortgages that are taking life’s perks away. Variable interest rates on home-equity loans, lines of credit, automobile financing, credit cards and the like are also tied to market conditions. When one goes up, they all go up.
But it’s the mortgage payment that homeowners feel the most.
The decreasing quality of life is particularly acute in Orange County, recently ranked as the most expensive housing market in the country.
With a median price of $219,542 for resale homes and $276,000 for new homes, the county is fast pricing many buyers out of the market. Just 18% of county households could afford to buy a median-priced resale home in July, according to the California Assn. of Realtors.
As home prices have risen, more and more buyers have turned to adjustable mortgages. Because they carry significantly lower interest rates at first, adjustables require lower initial monthly payments and allow buyers to qualify for bigger loans.
For example, most adjustables now offer introductory “teaser” rates of 7.5% to 8%, as opposed to typical rates of 9.5% to 10% for adjustables that are no longer in their introductory periods, and 10.75% to 11% for today’s fixed-rate mortgages.
But the lower monthly payments provided by adjustables can be illusory:
- The “teaser” rates are artificially low--the product of promotional competition among mortgage companies--and will jump to a more realistic level after six months to a year. Typically, the rate increases 2 points by the end of the first year.
- If prevailing interest rates go up, the rates on adjustable mortgages will continue rising. Mortgage rates have already climbed a quarter of a percentage point in the last two months, and many bankers believe rates will rise another three-quarters of a point by the end of the year.
- Rising rates could eventually push an adjustable mortgage several points above the rate that a buyer could have obtained originally on a fixed-rate loan. Those who barely qualified at the introductory rates could soon find themselves unable to make monthly payments, especially if their incomes haven’t kept pace.
- Some bankers worry that if prevailing interest rates rise far enough to push adjustable mortgages to their lifetime ceilings--usually 5 or 6 percentage points above the introductory rates--the county will be awash in foreclosures.
A small change in the mortgage rate can make a big difference in the monthly payment. For example, a one-point increase translates into a payment boost of $113 a month for a buyer who borrows $160,000 for 30 years at an initial teaser rate of 8%.
That first adjustment to 9% would bump the monthly mortgage payment from $1,174 to $1,287. A second 1-point jump would push the payment to $1,404.
And that’s for principal and interest only. On a $200,000 home, property taxes will run $167 a month more.
In other words, the monthly loan payment would jump nearly 19% by the end of the first year alone. That’s bad news for workers whose pay raises often are tied to the consumer price index, which has been increasing at an annual rate of about 4%.
“Higher rates have an overall steamrolling impact on the economy,” said Wayne Miller, president of Orange National Bank.
“People will stay at home more to save money to make that mortgage payment, and there will be less spendable dollars for recreation and other consumer items.”
Many county home buyers are already feeling the pinch:
- Bill and Floy Hotarek both take home decent paychecks from Rockwell International, but they expect the teaser rate on their adjustable loan to jump this month by 1 percentage point. Another increase in six months could put them in a financial bind, said Bill, 53.
“When we looked at ARMs earlier this year, their rates had been fairly steady for the last few years, and we didn’t think they were going to go up a great deal,” he said.
The Hotareks took out an adjustable loan, Bill said, because they plan to retire in two years, sell their condo and move to eastern Washington, where they have a house--and a mortgage payment--on 3 acres of land and 14 more acres of apple orchards.
- Even with both Tammy Wilson and Richard Slaten working, they must make “little sacrifices” and live on a Spartan budget to save enough money to refinance their 10-year loan, which they must do within six years, Wilson said.
“It would be very easy to go out and charge everything, like some people do,” she said. “But when it comes time to refinance the loan, you couldn’t qualify because of the other debts.”
Their deal with the builder, the Mission Viejo Co., was a good one, she said. The financing carried an 8% rate for the first year, with annual 1-point increases to a maximum rate of 11%, which they reached this year.
Including property taxes, Wilson and Slaten are now paying $1,550 a month--about $500 a month more than their payments during the first year.
While rising mortgage payments may have crimped the style of some homeowners, few have wound up in the poorhouse. That’s because the value of their homes has been rising too.
“It’s kind of academic in Orange County,” said Blass, the Shearson Lehman executive. “Pragmatically, if a homeowner finds he can’t afford a home, he will sell before he loses any money.”
Still, borrowers must be careful, because mortgage companies often qualify them at the artificially low teaser rates, said Thomas T. Hammond, president of the Hammond Co. in Irvine, a regional mortgage banking firm.
Borrowers could face “payment shock” after the first one or two rate adjustments, Hammond said, and payment shock can turn into packing the bags if rates continue to rise.
Ensures Against Big Losses
Bank and savings and loan executives like adjustable mortgages, even though they make less money on them initially than they do on fixed-rate loans. The floating rate ensures against big losses if prevailing interest rates shoot up, as they did in the first half of the decade.
“The ARM is the biggest product, and all the focus is on the teaser rate,” said Hammond, whose firm offers a teaser rate of just 6.875% on a mortgage that adjusts monthly.
The plethora of adjustables on the market may also confuse.
“The public still doesn’t understand the adjustable loan, with all the different index formulas, margins, caps and start rates,” said Harvey A. Lynch, an executive vice president of Glendale Federal Savings, who is serving as acting president of Pacific Savings in Costa Mesa.
Indeed, borrowers taking out loans insured by the Federal Housing Administration almost always go for fixed-rate loans, said Gene Noble, an FHA real estate specialist in Santa Ana.
“The adjustable loans are available, but nobody wants them,” Noble said. “I haven’t seen one made in months. People like the certainty of a fixed rate.”
But the FHA can only insure loans of $101,250 or less--low by Orange County standards. The agency serves mainly lower-income buyers who can’t afford to put 10% to 20% down.
Methods of Qualifying
One of the more worrisome aspects about adjustable loans is the way in which buyers are qualified.
In most cases, the monthly mortgage payment can’t be more than 28% of a buyer’s gross monthly income. All long-term monthly debt payments, including the mortgage, can’t amount to more than 36% of gross monthly income.
But if a buyer barely qualifies at the artificially low teaser rate, he may be unable to cope a year later when the interest rate is 2 points higher.
Because the upward adjustments can increase monthly mortgage payments by several hundred dollars, more foreclosures may be ahead, Hammond said.
That concern has caused the Federal Home Loan Mortgage Co., better known as Freddie Mac, to come up with new guidelines requiring lenders to qualify adjustable mortgage customers at the second-year rate instead of at the introductory rate. But the guidelines apply only to borrowers putting less than 20% down on a purchase.
Lenders argue that the adjustable loan is a better buy for consumers than a fixed-rate loan, because, in its short history, the adjustable has generally provided lower interest rates and lower monthly payments for most home owners.
And for the predictable future, lenders said, the adjustable should continue to be the better deal, because interest rates are expected to rise only slightly.
Besides, they noted, adjustable mortgage rates are usually pegged to an index that moves slower than the volatile prime rate.
But while the index is slow to move up with rising rates, it also is slow to go down as rates fall.
The adjustable loan is the only surviving product introduced during the days of “creative financing” in the late 1970s and early 1980s, when the supply of mortgage money was scarce and sellers and lenders came up with such ideas as balloon payments, “sleeping” second mortgages, wrap-arounds and “shared appreciation” financing.
Adjustables earned a bad reputation at first, partly because they didn’t have lifetime caps--limits on how high the rate could rise over the life of the loan. Today, adjustable mortgages typically have lifetime caps of 5 or 6 percentage points and annual increase caps of 1 to 2 points.
Enter the ‘Neutron Mortgage’
The early adjustables also had negative amortization, a feature that increased outstanding balances by turning unpaid interest into principal whenever prevailing rates rose above the six-month or annual cap, as they’re doing now.
The feature soon drove up monthly payments dramatically, often doubling them.
“It was a neutron mortgage: It left the home standing while it destroyed the homeowner,” said Stephen P. Renock IV, of Shearson Lehman.
Negative amortization all but disappeared from adjustable-rate mortgages in recent years, but Renock said he is beginning to see the feature return in adjustables.
