Adjustable Rate Mortgages - " all the makings of a classic horror story"

This one comes to us from Damon Darlin at the New York Times. Many of you may recognize the name, Damon is a regular contributor toThe Walkthru, the NY Times real estate blog.

Keep Eyes Fixed on Your Variable-Rate Mortgage

The raising of interest rates on millions of adjustable rate mortgages over the next several years has all the makings of a classic horror story.

As home prices appreciated from ridiculously high to unbelievably higher, more Americans began using mortgages that allowed them to buy more house for less of a monthly payment. Next year, a large portion of those rates move up and homeowners who opted for the exotic mortgages could find their payments doubled. Talk about bloody. They need to find a way to minimize the pain.

Many will refinance their loans. But for others, whose mortgages now exceed the value of their homes or whose debt payments exceed 40 percent of their incomes, there may be no other solution than to get out of their houses. With the housing market cooling, selling it may not be easy. Some may default on their loans.

With more homes on the market, prices could begin to fall. That reduces home equity — the difference between the amount borrowed and the total value of the home — and could force people whose loans change in 2008 and 2009 to consider selling, further accelerating the drop in prices. Some of those cities with the highest proportions of interest-only loans are also at the greatest risk of falling prices.
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On a personal level, however, there is going to be pain as homeowners struggle to make higher payments. In 2003, of all new mortgages, 10.2 percent were interest-only, meaning the homeowner paid only the interest for the initial period of the loan. According to Loan Performance, a research firm, 26.7 percent of all loans were interest-only last year and another 15.3 percent were payment-option adjustable rate mortgages, which allow homeowners to choose how much they paid each month.
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Traditionally, interest-only loans and adjustable-rate loans were used by people who expected to live in a house only a short time, but such loans have turned into “affordability products” as housing prices rose. The interest rate on the loans, while below that of conventional 30-year fixed-rate mortgages at the beginning, resets after 3, 5, 7 or 10 years, depending on the loan. So, homeowners who took out loans in 2004 could find, for example, that their initial 4.25 percent loan climbs to 6.25 percent or 7.25 percent next year.
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Sometimes, though, homeowners may have to take more drastic steps. The lender may not be interested in refinancing a home loan when the value of the home is below the loan amount. That could happen because a homeowner took out all the equity in a previous refinancing. (Freddie Mac estimates that Americans took $556 billion out of their homes through cash-out refinancings and home equity loans since 2004.)

It could happen if the price of the house has fallen or if the owner has been making only the minimum payment on a payment-option loan so that the loan balance has actually grown. (It is what the industry calls a negative-amortization loan). The best option then is probably to sell the house and scale back. Homeowners may also want to sell if they can clearly see that there is no way they can make the higher, refinanced payment.

In that case, it is better to act now before a few million other interest-only mortgage holders dump their homes on the market.