The Mortgage Trap

Homeowners who have adjustable rate mortgages, or ARMs, could find themselves struggling financially as rising interest rates make their monthly payments more costly.

Adjustable rate mortgages, or ARMs, differ from traditional fixed-rate mortgages in that fixed-rate loan payments will never change during the term of the mortgage. But an adjustable rate mortgage may offer a fixed rate and payment for an initial period of time, such as one, three or five years.

But after the initial period expires, both the interest rate and the monthly payment adjusts on a regular basis to reflect current market interest rates.

ARMs are also easier to qualify for versus fixed rate loans, as the initial rate and payments are typically a lot lower, and buyers can often get a bigger ARM loan and buy a more expensive house than they could with a fixed-rate mortgage.

But as interest rates have marched upwards since June 2004, many homeowners with ARMs are seeing their interest rates adjust upward faster than they thought and their payments rise higher than they can afford. According to a recent survey by roper Public Affairs for TrueCredit.com, 27 percent of homeowners believe that higher interest rates will make it difficult for them to make their mortgage payments.

About 18 percent of homeowners have ARMs, according to the Mortgage Bankers Association. But more than 25 percent of new mortgages in the first quarter of 2006 were ARMs, which is a significant increase from two years ago. According to industry estimates, this year over $330 billion worth of ARMs will adjust upward.

A Strong ARM Adjustment

On a $200,000 ARM that began few years ago, the initial rate was around 4.5 percent. When the ARM adjusts to 6.5 percent, the monthly payment will increase from $1,013 to $1,254, or a rise of almost 24 percent.

Although interest rates have increased more than 4 percentage points since 2004, most ARMs typically cap the amount of the annual rate increase to 2.5 percentage points per year. Therefore, these increases are only just the beginning and it's very likely that the people experiencing an increased ARM payment this year will see a similar rise again in 12 months.

The Perfect Storm for ARMs

Rising payments on ARMs are coming at a time when homeowners are getting slammed by rising expenses in other areas. Rising energy and gas prices, higher minimum payments on credit cards and higher interest rates and payments on home equity loans are creating a "perfect storm" that can increase household expenses by 25 percent or more. Adding a higher ARM payment on top of these expenses may be unmanageable for some homeowners and something will have to give.

Rising home values had been the way to ride out the storm for some financially strapped homeowners. The strategy was to tap their home's rising equity by either taking out a home equity loan or refinancing with a larger mortgage and taking additional cash out in the process. But now, since home equity loan rates have surged from 4.5 percent to 8.25 percent and home values have stopped rising and even fallen in some markets, this strategy is no longer working.

Already nationwide mortgage delinquencies (mortgages where one or more payments have been missed) are up slightly from a year ago. However, the worst may be yet to come. According to the Mortgage Bankers Association, the peak for mortgage delinquencies comes when loans are three to five years old, and the average loan is three years old or less.

According to local reports across the country, some homeowners with ARMs are struggling to make the higher payments and hold on to their houses. In the Fredericksburg, Va., area, the number of foreclosures has climbed from 19 in the first quarter of 2005 to 80 during the same period this year.

At a recent mortgage default counseling session held by a Consumer Credit Counseling Service in North Charleston, S.C., 11 people attended, eight of whom have ARMs, with higher payments being the problem. These sessions typically draw three or four people.

Home foreclosures rose last year in middle-class Chicago neighborhoods. The combination of rising interest rates and adjustable rate mortgages is viewed to be the main cause.

If you have an ARM, you need to know your options, what to do and when to do it.

  • Know How Your ARM works. Read your mortgage note and call your lender to find out how your interest rate and monthly payment adjusts to current market rates. Typically there is an initial period (for one, three or five years) during which the rate will remain fixed. After that, the rate will adjust based on an interest rate and on a date specified in the mortgage note. You will need to know how much your rate will increase, what your new payment will be and when it will increase.
  • Consider Refinancing to Fixed Rate Mortgage. The current rate on a 30-year fixed rate mortgage is about 6.75 percent, which is still lower than the 9 percent rate seen as recently as 2000. Rates on 5/1 ARMs, which carry a fixed rate for five years, then adjust after that are at about 6.58 percent; the small difference makes the fixed rate mortgage the safer choice. Also, consider consolidating your credit card and home equity loan debt into a new fixed rate mortgage.
  • Consider Refinancing Alternatives. But don't just rush in to refinance. Some mortgage lenders are seeing some increased activity by homeowners with ARMs refinancing to fixed rate mortgages out of fear that rates will reach 9 percent or 10 percent in a few years.

    Instead, carefully consider all of the options and angles. Consider refinancing alternatives such as loan modification, where your lender can switch your mortgage from an ARM to a fixed-rate loan for a fee of a few hundred dollars. While the interest rate might be slightly higher than what you could get if you shopped around for a new mortgage, the savings in closing costs can make up for this.

    Also, ask your lender about streamlined refinancing where the new lender can use the paperwork, appraisals and documents from your prior mortgage to reduce the paperwork and fees.

  • Call Lender Before Payments Are Late. If you know that you can't make timely payments when your ARM payment increases, don't wait to discuss your situation with your lender after you have missed a few payments. Instead, talk to someone at your bank or mortgage company before things get out of control. Your lender is interested in keeping loans from going into foreclosure and may be able to work out a deal with you. For example, they may offer a three-month grace period where the payments are added to the loan balance or they may offer to modify your loan by locking in an interest rate.
  • Cancel Unnecessary Fees. If you originally made a down payment of less than 20 percent, then you are probably paying private mortgage insurance, or PMI, with every monthly payment. If you live in an area where home values have appreciated since your took out the mortgage loan, it may be worth looking into canceling the additional PMI. If your homes value is such that your current mortgage balance is only 80 percent or less than the value of the home, then you might qualify. Your lender may require you to get a re-appraisal of your home, which may cost you a few hundred dollars, but that could save you a few hundred dollars each month by canceling the PMI.
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