Can You Put Off the Pain?

by Osman Parvez

I've never been a fan of Adjustable Rate, Interest Only, or Negative Amortization loans.

In recent years, these loans have appealed to buyers driven by monthly payments. Oh, I know they can work well for those who plan to hold the property for a short period, among other reasons, but many didn't understand how their loan would behave over time or the risks involved. Now, the first big wave of mortgage resets (the date when the interest rate "adjusts" to market) is starting to impact the market, no doubt contributing to Colorado's foreclosure epidemic.

Well, it looks like some people with ARMs are choosing to play double jeopardy in order to postpone the pain of rising interest rates.

Here's an excerpt from a recent New York Times article noting the trend.

Now, the first big wave of the mortgage boom is cresting as more than $400 billion worth of adjustable-rate mortgages, or about 5 percent of all outstanding mortgage debt, will readjust this year for the first time, according to Loan Performance, a research firm. Next year, another $1 trillion in loans will readjust.

When that happens, for instance, a typical borrower with a $200,000 A.R.M. could see his monthly payments increase nearly 25 percent when the A.R.M. adjusts from 4.5 percent to 6.5 percent. In total dollars, that is an increase from $1,013 a month to $1,254.

Yet instead of paying more now, many borrowers are refinancing into their second or third adjustable-rate mortgage, loan data indicate and industry experts confirm.

It remains to be seen how long interest rate pain can be put off. In a nutshell, borrowers refinancing an ARM with another ARM are again betting that by the reset date either their personal financial condition will have improved or interest rates will be lower. And while I shudder at a gambler mentality, there's nothing wrong with a decision based on level headed analysis of risk and return.

So, will rates go up or go down?

Since the early days of when I first started tracking the market, what surprised me is how often the market analysts are wrong. Short term concensus opinion is a little more accurate (although when it's wrong, the markets reel) but long term, market watchers often miss the call. The bottom line is that there's no crystal ball.

The key areas of concern are growth and inflation. If growth is slowing and inflation is kept in check, we might see an end to rate hikes soon. If inflation is becoming a problem, rates could keep increasing and stay high until it's under control again. The trick of course is that most economic indicators are trailing, meaning that what we're seeing now isn't the result of the lastest rate hike. It's more the result of rate changes 6 to 12 months ago, or even longer.

p.s. A recent commenter asked how the Boulder area will be impacted by ARM resets. It's worth elevating that question to post status.

I believe areas with higher education and median incomes like Boulder will be less impacted by rising rates and foreclosures. As my previous posts on the foreclosure epidemic pointed out, Boulder has already been holding up well compared to other parts of Colorado and I think it will continue to do so. At the same time the homes most likely to have been purchased by those of lesser financial strength (everywhere) are now most likely to be impacted by adjusting ARMs. Although the low end of Boulder's market is still very liquid, we're seeing foreclosures here too. As I've written previously, for savvy buyers willing to take the challenge of purchasing a foreclosed property, there's a potential silver lining.

note: Adjustable rate mortgages (ARMs) usually have a low rate for the first few years of the loan then reset (or "adjust") to market rates. Interest Only mortages allow the buyer to pay only interest for a set period of time with no paydown of the principle value of the loan. Negative amortization is where a buyer's payments don't even cover the interest on the principle, and the deficit is added to the loan.

Image: Lars Ivar

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