Mortgage reset shock: Not so bad

NEW YORK (CNNMoney.com) -- The number of adjustable rate mortgages (ARMs) up for reset is set to peak this fall, with an estimated $50 billion worth poised to adjust to higher rates in October.

The housing and credit markets are bracing for another blow, but recent trends may mean the reset shock will be less painful than expected, especially if the Federal Reserve drops its Fed Funds rate.

Ironically, the recent spike in defaults on ARMS is one reason why borrowers with resetting ARMs should be better off. Fixed-income investors are buying much safer investments, which has pushed up short-term bond prices and brought down interest rates.

"Many 2/28 hybrid ARM interest rates are based on one-year treasury yields," said said Allen Hardester, a mortgage consultant in Maryland. "The new rate will be more affordable."

From a recent high of 5.02 percent in mid-July, one-year Treasury yields have fallen to 4.09 percent as of Sept. 10. The reset rates of ARMs are calculated using an average of several treasury prices, but the final result should be around that 4.09 percent, plus a few additional percentage points, which is the margin.

With a margin of 2.75 percentage points (a common one according to Keith Gumbinger of publisher of mortgage information, HSH Associates), and it totals an interest rate of 6.84 percent, compared with 7.77 before.

On a $200,000 mortgage at 6.84 percent, borrowers will be paying $1,309 a month, $127 less than they would at 7.77 percent. For borderline borrowers, that could be the difference between being able to make the mortgage payments or not.

Furthermore, many economists believe there's a good chance the Federal Reserve will begin to lower the Fed Funds rate next week. Doug Duncan, the chief economist with the Mortgage Bankers Association predicts the rate will drop a quarter percentage point at each of the next two Fed sessions.

The yields on short-term Treasury bills tend to follow the same direction as the Fed Funds rate, so ARM reset rates could drop even further into affordable territory.

Said Keith Gumbinger, of the mortgage information publisher HSH Associates, "If you're coming due for an adjustment - I don't want to say you're in for a jackpot - but it could help some on-the-cusp borrowers."

But Richard DeKaser, chief economist for National City Corp., warned that if the Fed lowers rates by only a quarter point, versus half a point, Treasury bill yields may not move much. "That [quarter point drop] expectation has already been priced into short-term treasuries," he said.

Not all resetting ARM borrowers will benefit from T-bill yield declines. Many 2/28 hybrid ARM borrowers started their mortgages at such low "teaser" levels that their rates will rise the contractual maximum of three percentage points even if yields do remain low, according to DeKaser.

And one large class of ARM borrowers - as many as half, according to Gumbinger - who will not be seeing more affordable resets are those with adjustables tied to LIBOR, the London Interbank Offered Rate. Libor has been moving in the opposite direction as treasuries. On Sept. 5, the 30-day LIBOR stood at 5.80 percent, up from 5.33 percent 30 days earlier.

That would send the resetting LIBOR-based loans to about 8.45 percent, considerably higher than the ones tied to T-bill rates.

But the loan resets based on T-bills will certainly be reasonable compared with historical averages if yields remain low or fall further. At 6.84 percent they're not much higher than the current rate for a 30-year fixed, which averaged 6.46 percent last week, according to Freddie Mac.

"It does take some of the pressure off," said Gumbinger. "Maybe the borrower could now wait for a better deal [before refinancing]."