Will increasing use of adjustable-rate mortgages lead to future delinquencies?
When mortgage interest rates spike suddenly, many buyers move away from fixed-rate mortgages to adjustables because the interest rate is more favorable, and ARMs allow them to complete the purchase they negotiated before the rates went up. As one might expect, the sudden increase in rates from 3.5% to about 4.3% is causing people to take the 3.5% ARMs. Most don’t recognize the danger this creates.
Over the last 30 years of steadily declining interest rates, buying a house with an ARM didn’t create any long-term problems. Many buyers just waited for rates to go back down and refinanced into a fixed-rate mortgage. Some kept their ARM because the steadily dropping rates kept making their payment lower. Almost nobody recognized any risk to using an ARM because after such a long period of declining rates, everyone assumed rates would just fall forever — or for at least as long as they owned the property.
The problem with ARMs is only evident in a rising interest rate environment, and as I have discussed in numerous posts, we are at the bottom of the interest rate cycle, and rates are likely to steadily rise from here — perhaps for a very long time. Peak to trough on the interest rate cycle is usually 20 to 30 years.
Adjustable-rate mortgages have a contract interest rate that gets adjusted periodically based on the movement in some benchmark, often the federal funds rate or LIBOR. The promissory note usually has a contractual limit as to how high the rate can go, but the borrower is only qualified based on the initial contract rate. The assumption is that the borrower will see increasing wages, and if and when the rate goes up, they will be able to afford the higher payment.
This assumption carries hidden dangers. First, not everyone sees pay raises over time. Borrowers in their prime earning years may be maxed-out on the income they can be reasonably expected to garner. Second, even if the borrower does get raises, these raises may not keep up with the increasing cost of the mortgage. In either case, the borrower is either drained of all the benefit of their increasing pay, or they fail to keep up with the payments, go into delinquency, and end up as a foreclosure.
Perhaps the risk of ARMS will not be so great even if rates rise. Banks have become accustomed to giving loan modifications when borrowers can’t afford payments, and since loan modifications are the new borrower entitlement, people who foolishly take out ARMs at the bottom of the interest rate cycle will get bailed out by banks looking to avoid foreclosure. However, if house prices keep rising, and if the borrowers have any equity, the bank may not wish to extend a loan modification and may pursue a foreclosure instead.
Banks prefer borrowers to take out ARMs, particularly for the loans they keep on their balance sheets. ARMs pass interest rate risk onto the borrower. As long as the borrowers can afford the higher payments, and as long as the borrowers have equity that would allow the bank to foreclose, the bank really doesn’t care if the ARM becomes a hardship to the borrower; after all, it makes the bank more money.
Hopefully, borrowers are wise enough to take care of themselves.
Published: Wednesday, 26 Jun 2013 | 11:13 AM ET
By: Diana Olick | CNBC Real Estate Reporter
After hovering around record lows for the past few years, mortgage rates are rising dramatically. That has consumers not only shopping more but also considering adjustable rate mortgages, which offer lower rates and lower monthly payments.
These ARMs, many requiring interest payments only, were popular during the latest housing boom but quickly fell out of favor when safer, fixed-rate loan rates fell to record lows. ARMs accounted for 36 percent of mortgages in 2006 but just 4.5 percent today, according to Lender Processing Services.
Interest-only ARMs were banned by the new qualified mortgage rules, thankfully. Also, the fact that less than 5% of borrowers are using these products shows the sheeple are not that foolish, at least not yet.
The shift to ARMs is not visible on a grand scale yet, but it is beginning.
The average contract rate on the 30-year fixed rate rose to 4.46 percent from 4.17 percent, the Mortgage Bankers Association said Wednesday. At the beginning of May, rates were as low as 3.5 percent. Concern that the Federal Reserve will begin to pull back on its purchases of mortgage-backed bonds, which pushed rates so low in the first place, caused the most recent spike.
“Mortgage rates increased by the most in a single week since 2011, and refinance application volume dropped to its lowest level in almost two years. However, applications for conventional purchase loans picked up by more than 3 percent over the week,” the MBA’s Michael Fratantoni said.
Mortgage applications to purchase a home are rising for two reasons: Buyer demand is increasing, and those buyers are afraid rates will go up dramatically, so they want to lock in fast.
Purchase applications may have ticked up slightly, but they are still hovering at their four-year flatline.
Alicia and Ryan Diederichs say they are in a race against time. A job transfer recently sent them and their three young children to Oceanside, Calif. Now crammed into a small rental apartment, they are hoping to buy a house quickly.
“I’m afraid we’re going to miss the boat,” said Alicia Diederichs. “I feel like we might get priced out of the market in a few months, and just depending on the mortgage payment whether we could afford it if the interest rates go up more.”
Despite a catastrophic decline in house prices from the deflation of the housing bubble, people just don’t get it. Buyers can’t be priced out of a housing market. People may have to substitute down in quality somewhat, but someone, somewhere has to be buying the least expensive property in the market. And unless high wage earning doctors and lawyers start becoming content with 1-bedroom condos in bad neighborhoods, the masses will never get priced out. If there was any lesson I thought people would learn from the housing bust is that prices can and do come down if affordability forces them to.
The Diederichs need a large house to fit their family, but home prices are rising fast on the California coast, and they have not yet locked in a mortgage rate.
“Ideally we would do a 30-year fixed, but it’s all going to be dependent on the end mortgage payment, what we can afford, so we would have to look at an ARM potentially if rates continue to rise,” she said.
Or they could buy a smaller house. Do they really need a large house, or do they just want one? Or are they entitled to one?
The combination of sharply higher home prices and rising rates is squeezing buyers who are already facing tighter underwriting standards. In order to qualify for loans, they must fit into strict debt-to-income calculations, and those calculations change with every increase in mortgage rates.
“I think you’re seeing much more intense shopping where people are comparing rates between lenders, but also looking at different less conventional products,” said Glenn Kelman, CEO of Redfin. “They’re getting teaser rates, they’re buying it down, they’re trying different things to try to get back to the rate they saw last week.”
Some buyers are also being forced into adjustable rate loans in order to save deals that may have blown up in the past few weeks due to the rise in rates.
“Funny, people are rushing into higher-risk loans to save deals as rates spike. What happens in five years when their rate starts adjusting upward 2 percent per year? They blow up!” said Mark Hanson, a California-based mortgage and housing analyst.
As usual, Mark is right on with his analysis.
Hanson cautions that this may not be a “return to ARMs,” in general, but more of a “rush to ARMs” in the past four weeks. ARMs are harder to qualify for, and the rate on the 30-year fixed, while higher, is still historically low.
Rising rates will push some into riskier, adjustable-rate products, “whereas others will view rising rates as a sign that they need to lock in to a 30-year fixed now before rates move higher,” said Craig Strent, CEO of Maryland-based Apex Home Loans.
Of the two alternatives available, locking in the fixed rate is the wiser choice.
$500,000 HELOC abuse, 4 years squatting, 2 years in bank inventory
Everything bad about the housing bubble in one property. Nice.
The former owner of today’s featured property bought near the bottom of the last cycle in 1998. He refinanced in 2005 and took out $250,000. Later he took out a HELOC for another $265,000. A little over a year later, he quit paying, and the bank took four years to foreclose. After they did foreclose, they sat on the property for another two years before bringing it to market last week.
Nobody has made a payment to live in this house since 2007, and even with the prices going up, the bank still stands to lose $250,000 or more. IMO, they are getting what they deserved.
[idx-listing mlsnumber=”OC13123704″ showall=”true”]
11371 DELPHINIUM Ave Fountain Valley, CA 92708
$499,900 …….. Asking Price
$255,000 ………. Purchase Price
7/23/1998 ………. Purchase Date
$244,900 ………. Gross Gain (Loss)
($39,992) ………… Commissions and Costs at 8%
$204,908 ………. Net Gain (Loss)
96.0% ………. Gross Percent Change
80.4% ………. Net Percent Change
4.5% ………… Annual Appreciation
Cost of Home Ownership
$499,900 …….. Asking Price
$17,497 ………… 3.5% Down FHA Financing
4.38% …………. Mortgage Interest Rate
30 ……………… Number of Years
$482,404 …….. Mortgage
$135,100 ………. Income Requirement
$2,410 ………… Monthly Mortgage Payment
$433 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$104 ………… Homeowners Insurance at 0.25%
$543 ………… Private Mortgage Insurance
$0 ………… Homeowners Association Fees
$3,490 ………. Monthly Cash Outlays
($625) ………. Tax Savings
($649) ………. Principal Amortization
$28 ………….. Opportunity Cost of Down Payment
$145 ………….. Maintenance and Replacement Reserves
$2,389 ………. Monthly Cost of Ownership
Cash Acquisition Demands
$6,499 ………… Furnishing and Move-In Costs at 1% + $1,500
$6,499 ………… Closing Costs at 1% + $1,500
$4,824 ………… Interest Points at 1%
$17,497 ………… Down Payment
$35,319 ………. Total Cash Costs
$36,600 ………. Emergency Cash Reserves
$71,919 ………. Total Savings Needed