On the Money: Adjusting Your Mortgage

The Popularity of Adjustable Rate Mortgages Is Expected to Climb as the Fed Raises Interest Rates

By EILEEN ALT POWELL - Associated Press

NEW YORK, April 11, 2005 — As interest rates rise, more families are opting for adjustable-rate mortgages when they buy or refinance their homes. Unlike the traditional fixed-rate mortgages, which lock in a set rate for 15 years to 30 years, adjustable-rate mortgages typically start with low interest rates that rise over time.

The Mortgage Bankers Association, a Washington, D.C., trade group, says adjustable-rate mortgages, or ARMs, have accounted for more than a third of home lending activity in recent weeks, and their share could increase as the Federal Reserve continues to push up interest rates in coming months.

Families look to ARMs to keep their early monthly mortgage payments low. But because the rates on their loans can move up with the market, sometimes adjusting monthly, families risk having to pay considerably higher payments in the future.

Mari McQueen, a senior editor with Consumer Reports, worries that many Americans are too focused on monthly costs.

"I think consumers are approaching home mortgages the way they approach buying cars, focusing just on the lowest possible payment," McQueen said. "It's understandable, given the extremely high housing prices we're seeing across the country.

"But people are fixated on 'Can I afford this now?' and not considering what it will cost over time."

Options Are Plentiful

A variety of adjustable rate — and adjustable payment — mortgages are now on the market.

Keith T. Gumbinger, vice president of HSH Associates, a mortgage information service based in Pompton Plains, N.J., said the most popular are the hybrid ARMs, which promise a fixed rate for the first three, five or seven years and then adjust annually, generally in lockstep with Treasury rates.

The interest rate on a hybrid 5-1 ARM currently averages 5.66 percent nationwide, while the 7-1 ARM carries a rate of 5.90 percent, according to HSH data. When they begin adjusting, the increase can often be 2 percentage points a year or more; fully adjusted, the rates on the ARMs would both approach 12 percent.

By comparison, the rate on a traditional 30-year fixed rate mortgage averages 6.17 percent rate.

But the initial monthly payment on a $200,000 mortgage under the hybrid 5-1 ARM would be $1,156, or $65 less than the monthly payment for a 30-year fixed rate mortgage. Families who opt to pay interest only in the first few years could lower their monthly payment even further, to $943.

These hybrid mortgages are often chosen by young couples who aim to "trade up" to bigger homes in the near future, hopefully before the mortgages on their existing homes begin to adjust.

But if families don't sell or refinance their homes and the ARMs adjust upward, "they could find they've taken on more than they can handle," Gumbinger warned.

Choosing Your Own Monthly Payment

Another increasingly popular ARM is the payment option loan. These mortgages allow families to choose how much they want to pay each month — a minimum fee that doesn't fully cover the interest, an interest-only payment or a full payment that covers both principal and interest.

Kent Fullerton, 34, and his wife Cindi, 35, chose an option payment ARM when they refinanced their four-bedroom ranch-style home in Costa Mesa, Calif., in March. They have a 4-month-old daughter and hope to have more children.

"We know we're taking some risk with the new mortgage," he said. "But we didn't want a 30-year fixed mortgage because we're thinking we'll want to sell this house in a couple of years … and we got a better rate on the ARM."

Anthony Hsieh, president of LendingTree.com in Charlotte, N.C., an online service that helped the Fullertons find their mortgage, said young couples are especially attracted to ARMs because "affordability is their key concern."

The payment option loan is actually a "negative amortization loan" through which buyers can make early payments that don't fully cover principal and interest; the shortfall is added back into the loan, he said.

Hsieh gave this example. A home buyer takes a $160,000 adjustable payment loan with a 1 percent "teaser" rate. The minimum payment option is then set at $514.62 a month. After several months, the rate on the loan goes to the current market rate, say 5.5 percent. That would require a payment of $733.33 a month to cover just the interest or $908.46 to cover interest and principal. The rate — and thus the payment — adjust monthly after that, based on Treasury bill rates.

The family using this loan, Hsieh said, can opt for any of the payments in any given month, "which can be a good deal for people with seasonal income or who want to control their cash flow."

Home buyers can later step up monthly payments to make up for earlier shortfalls or they can hope that the appreciated value of their homes will cover the total loan when they sell the home, Hsieh said.

Like Gumbinger, Hsieh worries that as ARMs proliferate, home buyers may be exposed to risks they don't fully understand.

"The older generation remembers when interest rates were in the teens and remembers how much that can hurt when you have an adjustable-rate mortgage," he said. "The younger generation has only known the low interest rates — in the single digits — since the mid-1990s…There could be a sharp learning curve here."