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Home loans swayed by interest rates
Federal Reserve's rate hikes send monthly payments on adjustable-rate mortgages higher.
November 2, 2005: 10:40 AM EST
By Rob Kelley, CNN/Money staff writer

NEW YORK (CNN/Money) - While the Fed's recent series of interest rate hikes hasn't sent traditional 30-year mortgages through the roof, it's driving up rates on other popular home loans.

Short-term loans that have seen major increases, and the Federal Reserve raised the Fed Funds rate to 4.0 percent on Tuesday -- its 12th increase since June 2004. (Full story)

The Federal Funds rate is the amount that the Federal Reserve charges banks to borrow money, so increases in the rate lead to hikes in the cost of bank loans of all types.

One-year adjustable-rate mortgages (ARMs) averaged 4.91 percent last week, up from 3.96 percent the year before, according to Freddie Mac.

"If the Fed continues to raise rates, adjustable-rate mortgages will continue to get pinched," said Daniel Jester of Economy.com. "That's going to take people who are stretching to buy homes off the table."

Typically, increases in short-term rates eventually affect long-term loans -- like the 30-year fixed mortgage -- as well. But in a puzzling development for the Fed, long-term rates have not risen as quickly as short-term rates. (Full story)

Because short-term rates are now rising faster, they are making adjustable-rate mortgages look less desirable than even several months ago.

Adjustable-rate mortgages were only 28 percent of total mortgage applications in September, the lowest that figure has been in 23 months. The remaining 72 percent of the mortgage applications were for fixed-rate products.

Interest rates also have a strong influence on the terms of home-equity loans. The loans, which have a monthly payment based on the current interest rate, were popular while rates were low over the last several years.

"If the Fed continues to raise rates, it will continue to slow dampen demand for home equity loans and refinancing," said Nick Retsinas, Director of Harvard's Joint Center for Housing Studies. "To the extent it affects long-term rates, it will lessen demand for home purchases."

But the consumer heading to the bank this week won't see any major changes in rates -- they've already been incorporated into prices of new adjustable-rate and fixed-rate mortgages.

"When the Fed raised rates again to 4 percent, the market had already discounted that," said David Lereah, Chief Economist at the National Association of Realtors. "But over the next month, the markets will start expecting the Fed to raise rates again to 4.25 percent and that's going to push rates again."

The only product that is directly affected by the Fed is the home-equity line of credit (HELOC), which has a fixed interest rate for a very short period, and then changes to reflect the federal funds rate.

For a $50,000 loan on a $250,000 home, to be repaid over five years, the payment would rise from $960 to $967 a month if an interest rate hike pushed the APR from 5.75 to 6 percent. But if you got your loan at a 5.75 APR, and it increased 3 percentage points -- as the Federal Funds rate has over the last year and a half -- your payment would rise from $960 to $1,032.

Looking forward, those with adjustable rate mortgages will be forced to contend with rates -- and monthly bills -- ratcheting up.

"Of course it depends on when the loans are set to reprice," said Lereah. "But for those going to reprice it's going to be at higher levels, and that's a little interest rate shock that should slow home sales a little bit."

Adjustable-rate mortgages start with an interest rate that is below that of fixed-rate loans, but then begins to adjust upwards based on interest rates after an agreed period. For instance, the popular 5/1 ARM would charge less than the a comparable fixed-rate loan for 5 years, but then ratchet up after that period. So those who took out 5/1 ARMs in 2000 are the ones who will be feeling the rate hikes.

Those considering variable-rate products would do well to anticipate the future hikes in the federal funds rate. If monthly mortgage payments are likely to jump up, consumers need to make sure their budgets are ready.

"Consumers need to ask themselves as they shop for a loan if over the next few years their employment can absorb these payment increases," said Harvard's Retsinas.

"In hot housing markets, where many are turning to interest-only option ARMs, they will have to be prepared to absorb the interest rate risk."

Fixed-rate mortgage such as the 30-year charge a set interest rate throughout the life of the loan, making budgeting easy and protecting against interest rate increases. The average rate for a new 30-year mortgage reaches 6.15 percent last week. (Full story)

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For an explanation of the interest rate yield curve, click here.  Top of page

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