Sunday, December 26, 2004



Knight Ridder/San Jose Mercury

Here's a frightening figure: Of all the mortgage applications Americans filed the first full week in December, just over a third were for loans with adjustable rates.

That's been the pattern this year, according to the Mortgage Bankers Association, whose polls cover about half the mortgages issued in the United States.

The allure of ARMs could turn out badly -- not just for those borrowers, but also for everyone else.

When first issued, ARMs invariably charge lower rates than fixed-rate mortgages such as the standard 30-year loan. ARMs then change rates periodically as prevailing rates go up and down, while fixed mortgage rates stay the same.

The low initial ARM rate allows the borrower to qualify for a bigger loan, helping people buy in today's hot housing market. Hence ARMs' popularity.

Last year, ARMs accounted for just 19 percent of new mortgages -- about half this year's rate. But for high-risk borrowers, ARMs comprise more than half of all loans, according to LoanPerformance, a San Francisco mortgage data provider.

And how will these borrowers cope if the Federal Reserve continues pushing interest rates up -- as it did Dec. 14 -- for the fifth time this year?

Simple: Their monthly payments will go up -- by a lot, in many cases. Those households will, thus, have less to spend on other things, or to save and invest. That's sure to hurt economic growth, affecting us all.

People who can't afford their new, higher payments may lose their homes in foreclosure or be pushed into bankruptcy.

It's impossible to say just how serious this could be because we don't know how high rates will go, and because there are so many different ARM products -- from those that adjust every month to those that don't make the first adjustment for 10 years.

But it's clear that ARMs don't offer very good deals today.

The average one-year ARM, which changes its rate every 12 months, starts at 4.21 percent, according to HSH Associates, the Pompton Plains, N.J., tracking firm. Ordinary 30-year fixed-rate loans average 5.76 percent, with some charging as little as 5.30 percent.

This means the upfront saving you'd enjoy with an ARM is too small to offset the risk of higher rates later. Typically, ARMs can go up as much as 2 percentage points a year, to a maximum of 6 points over the life of the loan. So today's 4.21 percent ARM could go to 6.21 percent in 12 months, or 10.21 percent in as little as three years.

And rates are much more likely to go up than down.

The Federal Reserve has raised the federal funds rate to 2.25 percent, from 1 percent in June. Most experts expect the Fed to keep going until the rate is at 3, 3.5, even 4 percent.

The indexes used to figure ARM adjustments tend to follow the Fed moves. For example, the one-year London InterBank Offered Rate, or LIBOR, has gone from about 2 percent in May to 3 percent today.

An ARM typically adjusts to a rate 2.75 percentage points above the index. So an ARM keyed to the LIBOR rate would go to 5.75 percent were it to adjust today.

If the Fed raises rates another percentage point, the same ARM could go to nearly 7 percent a year from now -- and you'd kick yourself for missing today's low fixed-rate deals.

What if you already have an ARM?

``It's time to get out'' and refinance with a fixed-rate mortgage, says HSH spokesman Keith Gumbinger.

Despite the Fed's moves, rates on fixed loans have not gone up -- yet. In fact, the 30-year fixed rate is about half a percentage point lower than it was when the Fed hikes began. This is because the long-term interest rates that guide fixed mortgages are governed by forces the Fed does not control, such as foreigners' hunger for U.S. Treasury bonds.

In other words, says Gumbinger, this is a sweet spot -- a chance to get out of that risky ARM while the gettin's good.


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