Low rates defuse 'exploding' ARMs

NEW YORK (CNNMoney.com) -- A wave of resetting adjustable rate mortgages had been poised to add to the flood of foreclosures as their rates jumped.

Some 420,000 hybrid ARMs are scheduled to reset in 2009, according to the Treasury Department. A year or so ago, it seemed that many of these loans were going to see their interest rates reset to as high as 12% or more.

But then interest rates started falling, hitting lows they hadn't seen in 37 years.

"Many people are actually seeing their adjustable rates fall," said Barry Glassman, a financial adviser with Cassady & Company. "Some loans are resetting even lower than some fixed-rate loans."

A ticking time bomb. Adjustable rate mortgages start out with a two or three year period of low introductory rates, sometimes called "teaser rates." After that, the interest rates start to adjust according to a set schedule - sometimes as often as monthly or as little as once a year - until the mortgage is paid off.

For the most part, this was a recipe for disaster. Many homeowners took out ARMs because they couldn't afford the monthly payments that came with a 30 year fixed-rate loan. They were counting on having the value of their homes appreciate and then refinancing. Instead, home prices have plunged a record 18.2% according to the S&P/Case-Shiller index.

But as the economy soured, interest rates dipped.

"We thought that the 8% interest loans would reset to about 12%," said Alan White, a law professor at Valparaiso University who has studied the lending industry's mortgage modification efforts, "but they only went to 9% or less."

The adjustments are calculated by adding what's called a margin, which is a number of percentage points agreed to when the mortgage is first issued, to an index.

The index that most hybrid ARMs are tied to is the London Interbank Offered Rate (Libor). So, homeowners whose loans are resetting will get new interest rates equal to their margins, which range from about three percentage points for the lowest risk borrowers to six percentage points for those who at higher risk, plus the current Libor rate.

In 2007 when Libor rates hovered near 6% there was a great deal of concern about so-called exploding ARMs that would jump from 7% to as high as 12%. But with Libor now at less than 2% - loans are resetting at under 8%.

Some of the lower-risk ARM borrowers that only have three point margins are actually seeing their rates reset lower, in the range of or 4% or 5%.

Still, all this doesn't mean that some ARMs aren't still going awry.

"Our foreclosure prevention counselors are continuing to see delinquencies caused by ARM resets," said John Taylor, CEO of the National Community Reinvestment Coalition (NCRC).

And when Libor rates rise again, as they inevitably will, resetting adjustable loans will inflict a great deal of pain.

Don't be seduced by low ARM rates. That's why Steve Habetz, a Connecticut-based mortgage broker, warns his clients to refinance into 5% fixed-rate loans, even when their ARMs reset as low as 3%.

"It's a sucker play to stay with that ARM," he said. "You can buy yourself a lot of security by refinancing into a fixed-rate loan."

Habetz convinced one of his clients, Brian Rosenfeld, an attorney living in Stamford Conn., that it was better to forego the short-term savings he was getting with his hybrid ARM for a low, fixed rate loan.

His ARM recently reset to 5%, up slightly from his old rate of 4.375% but still a bargain, and he's currently in the process of refinancing.

"Right now, I'm playing a waiting game," said Rosenfeld. "When the fixed rate gets down near 5%, I'll refinance."

Option ARM resets will be worse. While the threat of traditional ARMs has been somewhat defused, another breed of exotic mortgage - option ARMs - will undoubtedly force more people out of their homes.

"Payment shock will continue to be a problem primarily because of recasting option ARMs," said Valparaiso University's Alan White.

Fitch Ratings, which rates mortgage backed securities, estimates there are about $200 billion worth of option ARMs out there, with nearly $30 billion scheduled to reset in 2009 and $70 billion in 2010.

These mortgages, also known as negative amortization loans, permit borrowers to make minimum monthly payments that don't even cover interest costs, much less any of the loan balance. Teaser rates were sometimes as low as 1%, even though the actual interest rate being charged was much higher - closer to 8%.

And most option ARM borrowers choose to make the minimum payments, which means that the difference between that and the full payment gets tacked on to the balance of the loan, so that the principal grows over time instead of shrinking.

Borrowers are permitted to make minimum payments for as long as five years (although the minimum will increase after the first 12 months), or until the balance grows to 110% to 125% on the loan's original principal. When that happens, the lender automatically turns the loan into a normal, fixed-rate, fully amortizing mortgage which require much-higher monthly payments to pay down the loan balance.

Option ARM borrowers are in for a double-whammy; jumping interest rates and ballooning balances. So a $200,000 loan, which originally only cost about $643 a month at the minimum payment, could become a $250,000 loan at 8% interest requiring a monthly payment of $1,834.

That's a jump most homeowners won't be able to afford.

Says White: "These borrowers will see a huge payment shock, regardless of whether rates are low."