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Tick. Tick. Beware the mortgage time-bomb
That ridiculously low-rate ARM seemed like such a good idea at the time. But now, payments will be coming due in a big, big way.
By Jeanne Sahadi, CNNMoney.com senior writer
October 9 2006: 1:56 PM EDT
NEW YORK (CNNMoney.com) -- Mortgage rates have been trending down, but that won't do much to benefit those who signed up for low-teaser-rate adjustable-rate mortgages in the past few years.
An ARM charges an initial discounted rate for a period of time, after which it adjusts to market levels. When some types of ARMs with teaser rates of 2 percent or less reset, the rates are likely to jump to more than 6 percent - and even as high as 9 percent.
Current Mortgage Rates
Type Overall avgs
30 yr fixed mtg 5.84%
15 yr fixed mtg 5.53%
30 yr fixed jumbo mtg 6.14%
5/1 ARM 5.54%
5/1 jumbo ARM 5.75%
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That can mean a doubling in monthly payments owed for those homeowners saddled with the loans.
The jump in payments could be even bigger for some people. They could have a loan balance that's larger today than it was when they got their mortgage - a situation called negative amortization. And it's common with what are called "payment option" ARMs.
That's because the initial teaser rate is a "payment rate," not an interest rate. That means the market-rate interest on the loan starts to accrue from the get-go and monthly payments aren't enough to cover it, let alone pay down any of your principal.
There may also be a trigger ceiling, meaning when the balance reaches a certain level - say 120 percent of the original balance - the introductory terms will end and the rate will reset upward, according to Christopher Cagan, director of research at First American Real Estate Solutions, a mortgage information provider.
End result: A much higher interest rate on a bigger loan than the homeowner ever intended.
In the past two years, homeowners took out 1.3 million ARMs with teaser rates below 2 percent, according to Cagan's research.
On the decline: Forecast for 100 large real estate markets
Of those, 21.5 percent have negative equity, where the market value of the home is less than the amount owed. The number of people in that spot could go up significantly if home prices fall as forecast or if homeowners with teaser-rate-ARMs experience job loss, illness, divorce or a death in the family, which are the main causes of mortgage default.
Certified financial planner Mari Adam knows of a couple hit by this mortgage nightmare first hand. With two kids in college, the two-income couple thought they could lighten their load by refinancing their fixed-rate mortgage into a low-rate ARM.
They got a 1.2 percent ARM in February with a monthly minimum payment of $1,372. By April, the loan rate had reset, jumping to 8.375 percent, and their loan balance had ballooned by $3,000 in just two months.
Their new monthly payment: $2,216 if they want to pay interest-only or $2,300 if they want to start paying down principal as well.
"I'd call this an obscene loan," Adam said.
The situation could have been much worse, said Keith Gumbinger, vice president of mortgage information publisher HSH Associates. Some ARMs will let you make payments at artificially low rates for a few years.
Plus, at least the couple cited by Adam still have some equity left - less than before but at least some, Gumbinger noted.
Others aren't so lucky. A lot end up with negative equity. That makes it very tough to refinance to a better mortgage.
Many struggle to make their new inflated payments, putting them at risk of foreclosure. And selling may not be an option to cure the financial headache given the recent leveling off, or downturn, of home prices in many markets.
What you can do
If you're in a fix with your ARM, you might:
Get fixed: Moving into a fixed-rate mortgage is the best thing you can do so long as you don't have negative equity, agreed Gumbinger, Adam and Cagan.
If you've gotten your ARM recently, call the servicing number on your mortgage bill, let them know you've been sold a bill of goods and ask them if they can recharacterize your loan - a process in which they change the loan to a fixed-rate product without going through all the steps (and costs) involved in a full refinancing.
But if your lender won't let you recharacterize, which can be the case if your loan has been sold to someone else, you'll need to shop around for the best refinancing deal. (See tips on how.)
The latest average rate on a 30-year fixed is 6.30 percent; on a 15-year fixed, 5.98 percent.
If fixed doesn't work, go for a longer term ARM: If you can't afford the payments on a fixed-rate mortgage, a 5-year ARM may be your next best bet, Gumbinger said. With a 5-year ARM, the initial rate stays in place for five years, after which it will adjust each year after that. The latest average rate on a so-called 5/1 ARM is 6.10 percent.
If even those payments would be too much for you to handle, you could opt for an interest-only 5/1 ARM, or even an interest-only 3/1 ARM, which are likely to have slightly lower rates.
Interest-only ARMs charge you the interest owed on the loan, but you don't pay down any principal. As a result, you won't build equity or reduce your loan balance, but at least you won't add to it because you're paying off the interest, Gumbinger explained.
And next time you want to buy a home with a mortgage, be sure to read all the documentation (footnotes included), ask lots of questions and, Adam said, remember, "when someone offers you a below-market or above-market rate, something is wrong."