With ARMs, Rising Rates Pose Risks for the Unwary
Adjustable-rate mortgages are making a comeback in response to a steep rise in the cost of fixed-rate loans.
But industry experts worry that borrowers who have enjoyed a long period of declining interest rates may be unaware of how risky adjustable loans can be in a rising rate environment.
“The consumer, in his quest to get in a new home, is likely to gravitate to the cheapest product,” said Angelo Mozilo, chief executive of mortgage lender Countrywide Financial Corp. in Calabasas. “But they need to have the lender provide the maximum amount of disclosure on an adjustable loan to make an intelligent decision about whether they can afford the home if interest rates rise.”
The appeal of adjustable loans is that their initial interest rates, and monthly payments, are significantly lower than those of fixed-rate loans. Where the average rate for a 30-year fixed loan was 6.22% last week, the average rate for an adjustable loan was 3.49%, according to the Mortgage Bankers Assn. in Washington.
On a $200,000 loan, those rates work out to a monthly payment of about $1,227 for the fixed-rate loan versus $897 for the adjustable.
No wonder more home buyers are turning to adjustables, considering the surge in fixed-rate loan costs from less than 5.25% in mid-June. In July, adjustables -- also known as ARMs -- accounted for 26% of the dollar volume of total mortgage applications, the Mortgage Bankers Assn. says. That was the highest percentage in a year.
In other periods of rising interest rates, such as in 1999, ARM loans have accounted for more than 40% of all loans.
The catch today is that the lower rates on ARM loans probably are temporary.
From mid-2000 to mid-June of this year, adjustable-rate borrowers benefited from a steady decline in market interest rates. But if the economy continues to recover, current ARM borrowers face the strong possibility that market rates will rise further, pushing their payments higher as soon as the loans’ first adjustment date, said Keith Gumbinger, vice president at Butler, N.J.-based loan research firm HSH Associates.
What’s more, because of the way some ARM loans are structured, their rates could rise even if market rates stabilize near current levels, experts warn.
How soon rate adjustments could occur, and high ARM loan rates could go, would depend on the type of loan and on market interest rate trends.
Borrowers need to carefully consider six key elements of an ARM, Gumbinger said, to make sure that they can handle the risks:
* Adjustment periods. The day of reckoning with an ARM generally is the first adjustment date. That’s when the rate on the loan can move from the initial offered rate to either the “fully indexed” rate or the “rate cap,” whichever is less. (More on indexes and rate caps later.)
How quickly this day comes can vary widely. Some adjustable loans offer only one month’s respite from interest rate hikes, whereas so-called hybrid adjustables can offer up to 10 years of a fixed rate before the first adjustment. After that first adjustment, hybrid loans usually adjust their rates once a year.
In times of declining market interest rates, the best ARM loan deals are those that adjust frequently, such as the monthly adjustables offered by many big savings and loans, said Jay Brinkmann, vice president for research and economics at the Mortgage Bankers Assn.
In today’s rising-rate environment, however, more home buyers are likely to favor ARMs that offer a fixed rate for years rather than months.
But ARMs that offer longer fixed-rate periods also are more costly. Countrywide, for example, last week was charging 3.25% on ARMs that adjust once a year, while its rate was 5.5% for loans that offered a five-year fixed-rate period before the first adjustment.
* Index and “margin.” The fully phased-in interest rate on an ARM is calculated by adding a “margin” -- a set number of percentage points -- to an index. The most commonly used ARM indexes are the London InterBank Offered Rate, or LIBOR (a measure of banks’ short-term funding costs), and the one-year U.S. Treasury bill interest rate.
The benefit of the T-bill index is that it’s somewhat less volatile than the LIBOR rate, Brinkmann said. But as a result, most banks charge a bigger margin on T-bill-based loans.
Typically, adjustables will be priced at the LIBOR rate plus 2.25% or the T-bill rate plus 2.75%, he said.
All lenders have historical data on the movements of these indexes for borrowers to review on request, Mozilo said. That should give a borrower a fair idea of how the rates on various loans might change over time.
Because the indexes are short-term interest rates, their moves depend in large part on the Federal Reserve, which controls U.S. short rates.
For now, the Fed is pledging to keep short rates at current 45-year lows, which is a help to ARM borrowers. But if the economy continues to recover, many experts believe the Fed will start raising rates sometime in 2004.
The Times publishes key mortgage indexes daily in the Business section. They appear on Page C6 today.
* “Teaser” rates. Teaser rates, which are low introductory ARM rates that can quickly expire, are less common today than they were a few years ago, Gumbinger said. But some banks still offer them.
Borrowers should ask whether an offered rate is a teaser. If it is, an ARM’s interest rate may rise at the teaser rate’s expiration even if market rates are stable or falling.
* Rate caps. Almost all ARMs have a ceiling on how high rates can go at each adjustment period and during the life of the loan. The most common caps on traditional ARMs restrict the rate from rising more than 2 percentage points per year and by more than 6 points over the life of the loan.
The exception: Hybrid loans often have higher rate caps for the first adjustment period, Gumbinger said. A hybrid that offers a fixed rate for the first seven years, for example, might have a 5-percentage-point rate cap on the first adjustment and 2 points thereafter.
That means a loan that starts at 5% could jump to 10% at the first adjustment date, depending on where market interest rates are. That would boost the monthly payment on a $200,000 loan to about $1,755 from $1,074.
* Payment caps. Some lenders cap the maximum amount that payments can rise in any single adjustment period. For instance, a lender may say that if the rate adjustment would cause a borrower’s monthly payment to jump from $1,000 to $1,300, the borrower would have the option of making a lower payment -- say, $1,150.
But the smaller payment may not be in the borrower’s best interest. That’s because the amount due based on the interest rate adjustment still would be owed. If it’s not paid because the borrower opts to use the payment cap, the $150 shortfall in the above example would be added to the loan balance.
That causes something called “negative amortization,” which means that the borrower’s loan balance grows with every monthly payment. Borrowers pay interest on interest, which can be very costly over time.
* Prepayment penalties. Increasingly, ARMs -- particularly those with teaser rates -- impose penalties on borrowers who pay their loans off early, Gumbinger said. The penalties vary, typically expiring within three to five years from the date a loan is made.
These penalties are imposed because the lender is providing a loan at a loss for a short period and needs to make sure the loan will remain outstanding long enough to recover that loss, Brinkmann said. But there are few industry standards for how high a penalty can be and how long it might apply.
Consumers should carefully read mortgage documents to see whether penalties would apply. They also should make sure that the contract stipulates that any penalty would be waived if the loan is repaid because the house is sold rather than refinanced, Gumbinger said.
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Times staff writer Kathy M. Kristof can be reached at kathy.kristof@latimes.com.
