With the popularity adjustable-rate mortgages (ARMs) have earned amongst consumers in the rising rate environment, concerns arise whether borrowers in these loans, instead of fixed-rate mortgages, will be challenged to pay their monthly dues once the rate on the mortgage adjusts. So, are the worries overstated?
Well after an ARM loan is closed, the rate on the loan can increase even if mortgage rates do not climb up. Most ARMs start out at a rate that is lower than the index, such as the 1-year Treasury, the Cost of Funds Index or 1-year LIBOR, plus the required margin. For example, on a 1-year Treasury-indexed ARM that has a starting rate of 4%, a Treasury index of 4.5% and a 2% margin, the borrower will make payments based on a 4% rate the first year, but the following year, the 2% margin, plus the current index will apply. Therefore, if the Treasury index were to stay at 4.5%, the rate on the loan would jump to 6.5%.
Currently, the 1-year Treasury-indexed ARM averages 4.08%, according to Freddie Mac. The Mortgage Bankers Association of America recently forecasted this ARM rate will average nearly 5% next year and 5.8% in 2005.
As for the 1-year Treasury index itself, the group forecasts the average yield will reach 5.7% by 2007.
According to the Consumer Federation of America (CFA), a $100,000 ARM loan with a 6% initial rate that increases by 1% would result in an estimated annual increase of $780 in mortgage payments. A 4% increase would reportedly result in $3,330 more annually.
Most ARMs also have rate and/or payment caps that can apply annually and over the life of a loan, therefore, the adjustment is capped regardless of how high an index were to rise. Although some ARMs cap interest increases at 2 percentage points annually and 5 percentage points for the life of the mortgage, other ARMs do not, CFA warned, and annual increases in mortgage payments could exceed $10,000.
In a recent announcement, the CFA expressed concern about the risks ARMs pose to lower-income and minority borrowers in particular, and urged lenders to fully disclose the risks involved with these mortgages to consumers. The Washington, D.C, nonprofit group said it surveyed 1015 adult Americans in July and found that those two consumer segments are most likely to prefer ARMs over fixed rates, and are likely to be hurt by rising interest rates.
"The good news is that about two-thirds of Americans not only prefer fixed-rate mortgages but appear well-aware of the risks of ARMs," CFA Executive Director Stephen Brobeck in a written statement. "The bad news is that lower-income and minority Americans are not only those most likely to prefer ARMS but also those with the poorest understanding of their risks."
Historically, affluent consumers who could afford mortgage rate increases were most likely to purchase ARMs. But now, ARMs are the mortgage of choice for over one-third of all applicants and are being marketed by some lenders to all potential buyers -- regardless of their income or assets, the group said. Findings of one report also indicated that "subprime borrowers are more than twice as likely as those with high credit scores to purchase ARMs," CFA said.
"Lenders who aggressively market ARMs to lower-income consumers and those with low credit scores are acting irresponsibly," Brobeck said. "Given the high probability of interest rate increases, an adjustable rate loan made to a family which can barely afford the initial monthly payments represents a ticking time bomb."
Jordan Ash, a financial spokesman for ACORN, or the Association of Community Organizations for Reform Now, agreed with the CFA's position. He said it is common for many low-income and minority borrowers to end up in abusive subprime ARM loans. Many lenders in the subprime market do not fully disclose the terms and risks of ARMs to borrowers, fail to consider borrowers' future income situation, and in some cases, even lead borrowers to believe they signed for a fixed-rate loan when they actually signed for an ARM loan. Plus, subprime ARM loans tend to have much higher interest caps than prime loans and saddle borrowers with additional risks. He said it is common for a subprime ARM to have a 6% maximum cap.
In line with CFA's comments, Raphael Bostic, Ph.D., of the Lusk Center for Real Estate at the University of Southern California who specializes in tracking the home mortgage market, said ARMs are not a concern now, but could cause problems for homeowners in three to seven years as they convert from fixed to adjustable rates.
"If interest rates increase, some buyers may not be able to afford higher payments and may have to sell their homes," Bostic said in a written statement.
CFA's Brobeck added, "who can say that, in the next decade or two, there will not be another world economic crisis, like the 1970s Arab oil embargo, which drove interest rates up over 10 percent."
Michael Schoendeck, a Freddie Mac economist, said that "looking forward I don't see short-term rates going up around 10% anytime soon." He also pointed out that a good share of current ARM originations are hybrid ARMs, where the rate is fixed for a period usually of 3, 5, or 7 years and adjusts thereafter.
"Everyone kind of plays up about 'Oh, you know people getting into ARMs, they're raising their debt burden if rates go up,' but you also have to consider whether it's a hybrid ARM, when that first adjustment will happen, you also have some protection with interest rate caps," Schoendeck said.
"After that it depends on your own risk preference, if you think you're only going to stay in that home for five years, the risk isn't all that large. It compensates for the risk with the lower starting rate," he added. "ARMs work well for a lot of people, if you look at the jumbo loan market about 60% of jumbo loans are in an ARM product and that's pretty much they're the easiest to qualify for with such a large loan. Again, you can worry about the lower income, but then again you should also worry about the higher income."
According to Fitch Ratings, rising interest rates will not substantially affect the performance of longer-term hybrid adjustable-rate mortgage loans. The ratings agency analyzed the loan characteristics and performance data of prime 30-year jumbo fixed rates and prime jumbo hybrid ARMs securing residential mortgage-backed securities issued between 2000 and 2003. Although the product is "still fairly new" and has not been tested during an extended period of rising rates, Fitch said it found that the jumbo ARMs with a fixed-rate period of five years or longer performed similarly to jumbo fixed rates. However, ARMs with a fixed rate period of three years, underperformed fixed rates well before the three-year rate reset.
Delinquencies of 60 days or more as a percentage of original balance indicated that borrowers who financed their home with a shorter-term hybrid for affordability reasons are more likely to have greater payment shock risk and, therefore, a higher propensity to default than those with fixed rates or longer-term hybrid ARMs, Fitch said.
While the future performance of ARMs is still uncertain, Schoendeck said their popularity will start diminishing as their share will probably go below their level of one-third by the first quarter 2005.
ARMs, like any other mortgage, have risks, and "we encourage everyone to shop around and be fully informed about the characteristics of the mortgage they are being offered," Schoendeck said.