The Fed, rates and loan mods

Monday, March 22
Written 10:40 a.m. EDT

THE FED AND MODIFICATIONS: Mercedes, a real estate agent from the D.C. metro area, asks: "I read with great interest your information. (On March 31, the Federal Reserve will stop buying mortgage-backed securities from Fannie Mae and Freddie Mac, returning control of interest rates to private investors.) I'm concerned about the interest rate going up and while the family working on a loan mod may still be in the process as of March 31. Will the rate increase if the loan mod is not completed by the end of March?"

That's really two questions. The first is: Will rates rise after the end of this month? The second is: Do increases in mortgage rates affect mortgage modifications?

The conventional wisdom says that mortgage rates will rise in the final nine months of this year. The Mortgage Bankers Association forecasts that rates will rise about half a percentage point from April through June, and then another half percentage point from July through December. So the MBA expects mortgage rates to be about one percentage point higher at the end of the year than they are now. That would bring the average 30-year fixed to around 6 percent.

The MBA's logic goes like this: When the Fed stops buying mortgage-backed securities, private investors will have to take the Fed's place, and those investors will demand higher interest rates than the Fed requires. That process will happen from April through June. (You might think that investors would require a greater return because they're afraid of borrowers defaulting, but it really has more to do with investors not wanting to get stuck with low-yielding bonds after the economy recovers and higher-yielding investments are available.)

In the second half of the year, the MBA forecasts the beginnings of economic recovery, with job creation and increased home sales. The improving economy would be reflected in higher interest rates overall, including mortgages.

That first rise in rates -- the one caused by the Fed's withdrawal from the mortgage market -- should have begun already, but it hasn't. Now economists and investors and bankers wonder whether the Fed's exit will affect rates. Brian Sack, executive vice president of the New York Fed, recently speculated that "the purchases have been primarily associated with the stock of the Fed's holdings rather than with the flow of its purchases. In that case, the market effects of the purchase program will only slowly unwind as the balance sheet shrinks gradually over time."

In other words, maybe investors will take the Fed's baton at the end of this month and run with it, and rates won't climb immediately.

I used to think that rates would jump at the end of this month because of the Fed's withdrawal. I have doubts about that now. But I concur with the MBA that mortgage rates will rise in the second half of the year as the economy improves. If it improves.

The second question Mercedes asks can be summarized as: What happens to mortgage modifications if rates rise during the mod process? With the Home Affordable Modification Program, or HAMP, a general rise in mortgage rates wouldn't affect rates that borrowers pay for modified loans.

A HAMP modification seeks to drop the monthly mortgage payment to 31 percent of before-tax income. The mod starts by reducing the interest rate to as low as 2 percent. It doesn't matter what's happening to mortgage rates generally. What matters is bringing the debt-to-income ratio down to 31 percent.

If dropping the rate to 2 percent doesn't get the debt-to-income ratio low enough, the term is extended up to 40 years. If that doesn't do the job, then interest is charged on only a portion of the principal.


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