According to the WSJ Real Estate Journal, 25%, or $2 trillion, of US mortgage debt is in the form of ARMs that will switch to variable rates in 2006 or 2007. For people that were already stretching to afford their monthly mortgage payments, these increases could put them in financial distress.
Combine this information with the recent CNNMoney article about overvalued real estate markets and the negative impact of interest rate increases on affordability, and my feelings are that a real estate correction is on the horizon...Christopher L. Cagan, director of research and analytics at First American Real Estate Solutions, Santa Ana, Calif., plays down the threat to the economy as a whole from resets. He figures most borrowers who bought their homes or most recently refinanced before 2004 are in good shape. That's because the surge of home prices in most parts of the country lifted the values of their houses well above the amounts due on loans.
The bigger risk is with people who bought homes more recently and haven't yet benefited from lots of price appreciation -- and, in some cases, won't necessarily benefit at all because their local markets are cooling. For a study released in February, Dr. Cagan examined adjustable-rate first mortgage loans made in 2004 and 2005, including refinancings. He figures about 7.7 million of these loans are outstanding, representing $1.888 trillion of debt.
About 1.4 million of those households face a jump of 50% or more in their monthly payments once their initial low-payment periods run out, Dr. Cagan says, and an additional 1.6 million face smaller increases that are still likely to strain their finances.
Assuming that home prices stay around current levels and interest rates don't rise sharply, Dr. Cagan figures about one million households eventually will default and lose their homes to foreclosure. That would cause about $110 billion of losses for lenders, he says.
Rates have a direct affect on affordability. For example, a jump in interest rates from 6 percent to 7 percent on a 30-year loan adds about 10 percent to a monthly mortgage bill. A homeowner who financed a loan of $200,000 at 6 percent would pay about $1,200 a month. At 7 percent, the bill would come to $1,330.
As rates rise, homebuyers who were already stretched may start demanding lower prices. "Low rates had offset unaffordability in past years," said DeKaser.
**interesting note ** I just received an email from a writer at SmartMoney magazine looking for someone who took out an ARM when rates were cheap and recently refi'd to a fixed rate... or as they put it "played the recent interest rate rollercoaster well". I don't fit the bill of what they are looking for (no ARM), but I feel that I "played it well" - we probably won't see 30-year-fixed loans as cheap as 5.375% again for at least a decade...
14 comments:
This is just what real estate investors who buy and hold have been waiting for. When the tide rolls back into the ocean, we all see whos been swimming naked! Property owners who have stretched themselves thin will need to sell. Its time to buy, buy , buy!
Well I have a 5 year balloon at 3.75% but it not due until mid 2007. At that time my options will be to revert to adjustable, refinance, or pay off the balance. I'm not sure what the terms of adjustable rate is. Suppose I should take a look some time this year to see what the damage is.
I COMPLETELY agree with you Savvy. I think that fixed was the only way to go. That's what we did. Why go variable when the rates can pretty much only go up? If people can't afford the fixed house payment, maybe they should look for a lower priced house. We have friends that went with an interest only ARM. Talk about scary!!
I can see how it would be nice to have an ARM if you aren't planning on staying in your house for more than a few years. With a decent down payment and being able to pay off extra principal because of the lower payments, you could build up equity faster than you could with a fixed rate loan. If you aren't planning on staying in the house much past the time when the rate goes up, then the benefits may outweigh the penalty.
Somehow, I don't think that's the scenario savvy is talking about, though.
I just wrote a little about this too. I think the trick is knowing for how long to make the ARM. There are 7/1 and 10/1 ARMs out there, but hardly anyone knows about them. I got the fixed portion of my ARM at 5.75% and I know that'll be one of the lowest rates over the next decade. I think these ppl who are going to have payment jumps in 2006 and 2007 had 3/1 Interest-Only ARMs.
mapgirl- You bought your condo in 2003, correct? That's when I bought my house and I was able to get a 30-year fixed for less interest than your ARM. At that point in time, the benefits for getting an ARM weren't that great because fixed rates were so low.
Just to clarify, IO mortgages and ARMS are two seperate products. They are sometimes combined, but not always. Anyone who purchased a 3 year ARM 3 years ago will have a payment increase, not just those with IO.
I think everyone is over-reacting on this ARM issue. Yes, I'm sure there were a few people that stretched themselves with ARM instead of Fixed. But I would venture that outside of that tiny minority most people that took out ARM knew exactly what they were doing. ARM rates typically adjust quarterly or even annually and there is typically a cap of how much it can rise in a given year. And this is AFTER the fixed period is over. That means if you were way below fixed rate when you took it out, you probably have several years after it starts to float before the fixed becomes a better value.
Also, if you are an investor, ARM or even interest only makes more sense than fixed. Your first few years, you are not making enough from rentals so it makes sense to keep initial costs as low as possible. Then you can gradually bump up your principle payments as rents rise.
garublador - I agree with you completely. The problem comes when people use ARMs for the purpose of affording the payments. Those people often can't afford to move at the end and probably weren't making any extra payments during the fixed period.
MikeK has some good points, except for in scenarios like right now where interest rates are rising quicker than rents and real estate is stagnant. Many IO and ARM borrowers are hurting. You can see it in the foreclosure numbers.
I'm looking to buy a condo or home by this time next year. This will likely be a starter place and my timeframe for staying there is 5 to 7 years. If interest rates continue to increase, am I better doing a fixed or an ARM?
ScaredOfMoney:
I had the same dilemma as you recently. My fiance and I just bought our first home where we plan to stay for about 5 years (but who knows how long we'll really stay, we can't predict the future: kids, job changes, etc.).
We went with a 30yr fixed rate mortgage and have no regrets. Here are my thoughts on the options we did NOT choose:
5/1 ARM: I like to play it safe. Assuming we needed/wanted to stay over 5 years (again, who knows what can happen in 5yrs?), I didn't want to have to even think about higher payments if rates were rising at that time.
7/1 ARM: I was more comfortable with the "fixed" period of 7 years. This gave us a nice buffer if we wanted to stay longer than 5 years (certainly not more than 7). However, I found that the 7/1 rates we could find were only marginally lower than the 30yr fixed rates (when I was looking).
As a result, we went with the 30yr fixed rate mortgage. I was able to "buy down" the 30yr fixed rate (for just a couple hundred bucks at closing) to equal the 7/1 rate. For me this, this was cheap insurance, a good rate: same as 7/1, and peace of mind: no worries of a larger payment. EVER.
Could I have saved some money with a 5/1 ARM? Probably. However, when I read daily reports about rising rates, I sleep much better than if I had gone the ARM route. I don't even have to think about it, I'm locked in with a good rate.
This was my preference. Your situation may differ. The peace of mind was worth it for me. I might have considered a 5/1 ARM if I thought we wouldn't keep the house as long. I would have considered the 7/1 if it offered more of a savings over the 30yr fixed.
Good luck!
ScaredOfMoney, a good mortgage broker should be able to help you through this decision as well. If they can't, then find someone else whoh can. From what I understand there are some pretty shady brokers out there that don't tell you the whole story when it comes to buying a house.
I gather I'm one of the few people around who refinanced to a shorter term. When the rates dropped I went from a 30 year fixed that I'd had for about 2 1/2 years to a 15 year fixed. I'd been rounding the payments up from the beginning. With the lower rates, my payments went up about $35/month from what I'd been actually paying. I'm still paying it off at a slightly accelerated rate. I'm pretty sure that I'll pay it off early. Assuming I do, I'm going to throw a mortgage-burning party.
anonymous 1:01-
Good for you! I would have loved to refi to a shorter term, but by the time we could afford it, rates had gone back up a bit to where our 30 year rate was cheaper than the 15 year.
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