Mortgages
-- Rate Hike Survival Guide by Cybele Weisser
June 2006
A lot of boom-time home buyers bet that interest rates wouldn't
go up. Oops. Now, with mortgage rates rising, it's time to come
up with an escape plan.
As
the real estate boom inflated home values all over the country,
millions of would-be owners did whatever it took to join the party:
bid well over the asking price, hit up parents for a down payment
and resorted to ever more creative financing tools, from short-term
adjustable-rate mortgages to exotic interest-only option-payment
loans. Now that the party seems to be winding down, many of those
borrowers are going to be left with a messy cleanup.
As
many as 3 million homeowners holding more than a trillion dollars
in adjustable-rate debt will face an interest-rate adjustment
in the next two years, according to the Mortgage Bankers Association.
Assume that adjustment will be in one direction: up. If you shaved
your monthly payments by putting off paying principal, your day
of reckoning will be that much more intense.
Mortgage
rates are at their highest in four years, and with rates on ARMs
nearing those on fixed loans, you won't find any easy or cheap
solutions. "There are going to be people getting into trouble,"
says Christopher Cagan, the director of research at data provider
First American Solutions. He's found that nearly half of borrowers
who took out ARMs in the past year have 10% or less equity in
their home, making it hard for them to refinance easily or sell
at a profit, especially if prices in their local market have softened.
If
you are nervous about what your mortgage payments might look like
next year or next month -- or have already seen them increase
by hundreds -- now's the time to do some serious calculations.
The decision about whether to refinance is complex -- you must
factor in your budget, how long you plan to stay in your home,
your tolerance for risk and what fees you might pay to get a new
loan. The three families you are about to meet are grappling with
these issues. Read on to find out how our experts suggest they
survive the rate hikes coming their way.
The Hybrid Borrower
Locked In, but Not for Long
Two years ago, when Toni Lapp
bought a three-bedroom, 1 1/2 bath house in a neighborhood near
downtown Kansas City, the divorced mother of two figured this
wasn't the last house she'd own. So to buy the $207,500 home,
she took out a $162,000 mortgage with a rate that's fixed at 4.6%
for five years and adjusts annually after that, giving her a monthly
payment of just $833 at first vs. $958 if she'd used a 30-year
fixed-rate loan. "I realized, looking back, that I had never lived
anywhere longer than six years, so a five-year ARM seemed like
a safe bet," says Lapp, 38, a medical writer. But now, less than
two years later, she's wondering if that seemingly safe bet was
shortsighted.
Toni
Lapp Prairie Village, Kans.
Loan:
$162,000 5/1 hybrid ARM
Monthly
Payment
now $833
could
rise to $1,272
Today,
Lapp is not only thinking of staying longer than five years,
she's also considering investing more in her home. With
sons Ryan, 13, and Cory, 10, getting older, she feels that
her 1,500-square-foot house is too small, and she'd like
to have a family room and a second full bath. But worries
about her upcoming interest-rate adjustment have left her
paralyzed. Already, ARM rates are more than a point higher
than what she's paying. When Lapp recently checked the fine
print on her mortgage, she discovered that her interest
rate could jump as much as five percentage points when it
adjusts in 2009, to a rate of 9.6% and a monthly payment
of $1,272 -- a $439 increase. "That was a rude awakening
for me," she says. "On top of that, I think about the point
I paid for this loan and what a waste that would be if I
refinance or sell."
>> The Solution
Stand pat, and hope rates are lower in three years
One
thing is nearly certain: Whether Lapp gets a new loan now
or later (or sits tight and lets her mortgage adjust), she'll
have to write a bigger check someday. If she takes out a
30-year fixed mortgage today, her payment will go up by
$180 a month. If she does nothing, her monthly payment could
increase far more.
Lapp
needs a new mortgage, but when? The answer comes down to
mood as much as mortgage rates. Because Lapp is so nervous
about paying a higher rate, Tampa financial planner Elaine
Scoggins suggests she lock in a fixed rate soon. "She's
a single mom raising two kids, so she needs to consider
how much stress she will feel as she marches toward the
five-year period and sees rates jumping around," Scoggins
says.
But
if Lapp can stomach a bit of risk, chances are she'll come
out ahead by hanging on for a few more years, says Keith
Gumbinger, a principal with mortgage data provider HSH Associates.
"If she refinances now, she'll lose that nice low rate,
and there's no reason to assume that rates will be higher
than they are now when she comes up for the adjustment,"
he says, noting that because mortgage rates have historically
moved in five- to seven-year cycles, there's a good chance
that in three years they'll be headed back down. Another
reason to wait: Lapp isn't sure how long she wants to stay
in the home. To cushion the risk, Gumbinger suggests Lapp
build up her savings (she recently paid off her car loan,
freeing up a few hundred dollars a month). That way she'll
have cash on hand to cover more costly monthly payments
if rates are higher than they are today when her loan adjusts
or she refinances.
The
last consideration is Lapp's hoped-for renovation. She's
prepared to borrow another $20,000 to add a room and expand
the bath. Even though her home has appreciated modestly
since she bought it, she doesn't have enough equity to fund
the work by refinancing for more than her current mortgage
balance and taking cash out. Given that, a home-equity loan
(which would cost about $200 a month at today's 8% average
rate) is her best option, and she would likely recoup much
of her investment in an extra room and bath, even in a slower
housing market. Finally, Lapp shouldn't sweat the point
she paid on her original loan. Notes Los Angeles financial
planner Jeffery Harwood: "That's a sunk cost and irrelevant
to the decision about whether to refinance today."
What's
Your Worst-Case Scenario?
If
you lowered your payments by opting for an adjustable-rate
loan, do you know what could happen to your "amount
due" this year or beyond? Look up these key terms
in your mortgage paperwork to find out.
1
Index. Your rate is tied to an index with a baffling
name like the cost-of-funds index (COFI) or the constant-maturity
Treasury (CMT). You can find current and historical
data on 16 indexes at mortgage-x.com.
2
Margin. The interest rate you pay (now and in
the future) equals the index rate plus your lender's
margin, usually a few percentage points. Calculate
the total now to see if you should consider a refi.
3
Caps. To preview how bad it could get, look for
three numbers: The "first adjustment cap" is the most
your rate can rise the first time; the "periodic cap"
restricts each rate jump after that; and the "lifetime
cap" limits how much your rate can ever go up. Generally,
things have to get a whole lot worse for these caps
to offer much protection.
4
Early termination fee. This ding (typically 1%
to 3% of your balance) might kick in if you refinance
out of an ARM in the first couple of years -- and
wipe out the benefits of a new loan.
-- Kate Ashford
Forecast:
Pain
The Rise of Risky Mortgages
ARMS
RACE
The
growth of adjustable rate mortgages means more
homeowners are facing rate hikes soon, if not
already.
NO
PRINCIPAL
Buyers have been saving (for now) by paying only
interest. These IO loans made up more than a third
of mortgages last year, up from a sliver in 2001.
RATE
SHOCK
Anyone who relied on a home-equity line of credit
to buy a home is already paying more.
Note:
New mortgages include refinancings. Sources: Loan
Performance, HSH Associates (hsh.com)
As
the real estate boom inflated home values all over the country,
millions of would-be owners did whatever it took to join the party:
bid well over the asking price, hit up parents for a down payment
and resorted to ever more creative financing tools, from short-term
adjustable-rate mortgages to exotic interest-only option-payment
loans. Now that the party seems to be winding down, many of those
borrowers are going to be left with a messy cleanup.
