Same House, Lower Payments

Same House, Lower Payments

by Justin Martin
Ladies’ Home Journal, February 2007

If you have an adjustable rate mortgage, your interest payments might just skyrocket – unless you act now.

When Sharon Wright Jackson, a young widow with two small daughters, found a four-bedroom house outside Charlotte, North Carolina, for $158,000, she was thrilled. Her monthly mortgage payment began at a manageable $975. But recently her bill jumped to $1358 – and may climb again. Jackson, who works as a consultant, doesn’t know where she’s going to find the extra money, and she’s worried that she may lose her home. “My American dream has turned into a nightmare,” she says.

How did this happen? Jackson has an adjustable rate mortgage (ARM), on which the interest rate can rapidly spike skyward. And she’s hardly alone. As home prices soared during the 2002 through 2005 real-estate boom, lenders promoted ARMs aggressively. Someone who bought in 2003, for example, probably could have chosen between a fixed rate of up to 6 percent or an adjustable rate below 4 percent and for many, the decision seemed to be a no-brainer. What’s more, the initially low monthly payments of ARMs let buyers purchase more expensive homes than they could otherwise afford.

Today roughly a third of America’s 48 million mortgages are ARMs, and 2 million of them are due to reset to higher interest rates in 2007. Opting for an ARM makes the most sense when interest rates are high and thus likely to drop. Since interest rates two to four years ago hit historic lows, now there’s nowhere for them to go but up.

Some ARM holders have more traditional forms of these loans in which the interest rate is adjusted based on a financial index with which it rises and falls. Even with these loans, rate changes can mean the difference between affordability and foreclosure. Holders of traditional ARMs “face slow, agonizing water torture” says Keith Gumbinger, vice president of HSH Associates, a Pompton Plains, New Jersey, firm that tracks the mortgage market. To illustrate: If you bought your home in 2003, you could have landed a low rate of 3.7 percent on a 30-year ARM that adjusts annually. By 2006 the rate would have jumped to 7.8 percent. If your mortgage was $300,000, you monthly payments would have climbed from $1,380 to $2,160 in three short years.

But it gets worse. There are also riskier ARMs that now account for about 50 percent of all adjustable loans, Gumbinger says. These “exotics” often have astoundingly low teaser rates, sometimes as little as 1 percent. But the rates jump after a set period, generally one to three months. Other exotics, such as interest-only mortgages and payment-plan mortgages, feature complex terms whereby monthly bills start attractively but climb even faster and more unpredictably when a reset trigger – something you may not even be aware of – is reached.

Still more pain could be ahead. If interest rates rise again in 2007 and 2008 ARMS, whether traditional or exotic, will rise as well. Most ARMs have caps on how much the rate can rise in a single year (typically 2 percent) and over the life of the loan (usually 5 or 6 percent). But every 2 percent jump on a $300,000 mortgage ups monthly payments by roughly $350.

Faced with rapidly increasing payments, some homeowners may be overwhelmed. Between now and 2010, 700,000 homes will be foreclosed on because of teaser ARM resets, projects Christopher Cagan, director of research at First American Real Estate Solutions, in Santa Ana, California. Small wonder the foreclosure rate is on the rise again.

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So what can ARM holders do? First step: Know thy mortgage. A recent study by the Federal Reserve found that 35 percent of homeowners with ARMs didn’t understand how much the rate could increase at one time. Loan documents received at closing spell out crucial information such as rate caps and what events trigger payment increases. If you can’t find the papers, call your lender and demand a clear explanation of your loan’s terms. If your mortgage rate is about to skyrocket, try negotiating with your lender, who may be willing to extend your current low payments for a while.

Even if you negotiate successfully, however, you’ll only be delaying the inevitable rate hike. The longer-term solution is refinancing your mortgage. In rare cases, if you know your employer will be transferring you to a new city within the next three years, for example, or if you know that you will be moving in that time frame for some other reason, it might make sense to get another ARM – in this instance what’s known as a “3-1” ARM, which offers a low fixed rate for three years before jumping to an adjustable rate.

But in most cases the savvy move is to refinance from an adjustable to a fixed mortgage, assuming your home’s value and equity and your collateral permit it. Since the current rate on a 30-year fixed is around 6.5 percent (a rare economic occurrence you’d be wise to take advantage of), many homeowners saddled with ARM rates higher than 7 percent can switch to a fixed mortgage and actually see their monthly payments go down. But even if your payments go up in the short term, a fixed rate is protection against ever-rising adjustable rates. Bottom line? Now is the time to ditch that ARM.