Low-Rate Libor Mortgages Carry a High Risk

Lance Kotschwar knocked $704 off the monthly mortgage payment for his home with a loan tied to the short-term interest rate international banks charge each other.

The savings come from the 3% interest the mortgage charges, compared with the average 7% interest on a 30-year fixed-rate mortgage.

In the past year, about 18,000 U.S. homeowners have taken out such mortgages, whose interest rates are adjusted each month on shifts in the London inter-bank offered rate, or Libor, the Mortgage Bankers Assn. of America said. The Libor mortgage is among an expanding variety of loans lenders are offering to try to maintain the industry’s record growth and compensate for a decline in the profitability of traditional fixed-rate mortgages.

“I call it the mass customization of the market,” said Doug Duncan, chief economist at the association. Borrowers today can choose loans with adjustable rates that convert to fixed rates after three, five or seven years, fixed-rate loans that convert to adjustable, and loans that charge only interest for a set period. Libor-based loans account for about 1% of all mortgages, Duncan said.

U.S. mortgage volume rose to $2.03 trillion last year, eclipsing the 1998 record by 35%, according to the association. Consumers refinanced home loans to take advantage of the lowest mortgage rates in 30 years, as the Federal Reserve cut interest rates in an attempt to spark the economy.

Increased competition has hurt lenders’ profits, even as the mortgage market boomed. Closing costs and other fees on conventional 30-year mortgages fell to 0.56% of the loan amount last year from 2.56% in 1985, according to the Federal Housing Finance Board.

Lenders push adjustable-rate mortgages because profit margins on such loans are as high as 28%, compared with 24% for fixed-rate mortgages, said Jonathan Gray, an analyst at Sanford C. Bernstein & Co. The interest rate on the Libor mortgage is based on the rate charged for large loans between the most credit-worthy international banks. That rate is the benchmark for loans to countries and corporations. It tracks the Federal Funds rate, which the Federal Reserve uses to regulate the supply of money in the U.S. economy, more closely than other mortgage benchmarks do.

Libor bottomed at 1.73% in January. Interest rates on Libor mortgages fell as low as about 2.9% after lenders tacked on a service payment of 1.12%.

The low rate comes with a high risk. The rate adjusts monthly, making the loans best suited to wealthy borrowers, who can better weather the rapid rate shifts, lenders said.

Libor has been known to rise quickly when the Fed starts increasing interest rates, as it did in 1994. That year, Fed policymakers raised interest rates to keep the economy from growing too fast, and the 1-month Libor rose to 6.19% from 3.13%. The rate on the 30-year fixed-mortgage, by comparison, rose to 9.18% from 6.97%.

“Higher net-worth borrowers are spending a smaller part of their income on their mortgages, so if the rate rises it doesn’t severely impact their lifestyles,” said Steven Schnall, president of New York Mortgage Co., which has made about 45 of the loans since it began offering them four months ago. The average loan amount for a Libor-based mortgage at New York Mortgage is $1 million.

Kotschwar, a 36-year-old lawyer working for the U.S. House of Representatives, wouldn’t reveal the size of his loan. He is using the monthly savings to make up for income lost when his wife, Linda, left her job to stay at home with their 9-month-old son.

“I don’t see interest rates getting wacky any time soon,” he said. “If they do, I’ll refinance after the year is up.”