A call to ARM holders: Prepare
now for coming rate hikes on loans
By Michael D. Larson • Bankrate.com

ARM rates looked too good to be true a couple years ago. Now, it's clear they were.

Thanks to Federal Reserve Board rate hikes during the past 11 months and heightened inflation concerns, adjustable rate mortgage holders who got in when 1-year ARMs were going for around 5.5 percent have seen their rates and payments skyrocket. Thousands more who took out ARMs to keep their mortgage payments "affordable" as rates rose will soon be facing their first adjustments, too -- and the numbers won't be pretty.

Yet current ARM holders and people looking to take out new ones don't need to go into battle with Alan Greenspan unprepared. By saving money during their initial low-payment periods, buying down their loan balances and budgeting for a worst-case interest rate scenario, they can protect themselves from problems that will only get worse if rates keep heading higher.

"We're getting into the vicinity where some of these home buyers are going to start to see a little bit of a squeeze," says Don Ratajczak, director of the Georgia State University Economic Forecasting Center in Atlanta. "The natural tendency has been, 'Let's go as far as we can and the fixed rate isn't going to take us far enough, so then let's go with the adjustable rate.' That's fine and good if adjustable rates are going down or if your salaries are trending upward, but if these things are not trending up quickly enough, you're getting into trouble.

"People were really thinking that rates were going to be permanently low," he adds. "But people used to think they could get 20 percent a year on their stock investments, and now both of those assumptions have proven wrong."

Complicated product is hard to understand
ARMs are among the most complicated mortgage products to understand, and they can be downright dangerous when rates are rising. Yet many borrowers choose them because they feature lower rates and payments early in the loan term, similar to credit cards with "teaser" rates, that later adjust higher. How high depends on the performance of a market index, which can be anything from the yield on short-term government debt securities to the average interest western U.S. banks pay to depositors. Lenders take that index, add a margin and compute a new rate for borrowers at dates specified in the ARM contract.

Some ARMs have initial periods as short as a year or even six months. Others, known as hybrid ARMs, have fixed rates for three, five, seven or 10 years, then rates that adjust each year thereafter. Borrowers generally get the lowest teaser rates on loans with the shortest initial fixed period. That means a 1-year ARM will have a lower initial rate than a 7/1 hybrid ARM, which has a fixed rate for the first seven years. Regardless of the exact term, all of them usually cost less at first than 30-year fixed rate loans.

"For some people, they simply can't afford or qualify for a home with a fixed rate product and they're turning to adjustable rate mortgages as an alternative," says Brad Blackwell, senior vice president for retail mortgage lending at Washington Mutual Inc. The Seattle-based company is the nation's largest residential ARM lender.

Popularity follows rate moves
Over the last several years, the popularity of ARMs has fluctuated with interest rates. In the fourth quarter of 1994, when the Bankrate.com weekly average 30-year fixed rate climbed as high as 9.14 percent, 1-year ARMs accounted for almost 13 percent of the conventional mortgages originated, according to Federal Housing Finance Board data. 5/1 ARMs represented slightly less than 5 percent of that quarter's volume while 30-year fixed rate loans were 33.6 percent of the total. In the fourth quarter of 1998, when the Bankrate.com 30-year average dipped as low as 6.46 percent, only 4.3 percent of borrowers took out 1-year ARMs and just 1.1 percent used 5/1 loans. Almost 70 percent opted for the 30-year product.

That recent surge in fixed-rate loan volume means some borrowers wisely chose to lock in low. Because of that, they don't have to worry about the Fed hikes. But many people either didn't take advantage of the low rates to refinance into a fixed rate loan, chose the even-lower ARM rates available to free up cash for investing or simply couldn't get through to a loan officer before rates started climbing again.

Still others had no choice but to choose ARMs because fixed rate mortgages became too expensive. Thirty-year fixed rate loans breached the 7 percent barrier in early 1999 and eclipsed 8 percent late in the year. As a result, hundreds of thousands of borrowers are facing rate adjustments at the worst possible time in the past five years.

"When interest rates were low, it just looked awfully good," says Lew Wallensky, a certified financial planner at Lewis Wallensky Associates Inc. in Los Angeles. "But there's no such thing as a free lunch. There never has been and there never will be."

Easing impact of rate hike
Borrowers can't do much about the Fed, but there are ways to mitigate the impact of their date with interest rate destiny. First, experts say they need to take another look at their loan documents to figure out when their next adjustment is coming and how large it's likely to be.

Generally speaking, rate adjustments take effect on the anniversary date of the borrower's first payment, according to Eric Gotsch, vice president and regional sales manager with Chase Manhattan Corp.'s retail mortgage division. If someone closed on a loan in early January, the first payment wouldn't be due until March 1, so that would be the effective anniversary date. But lenders use the index value 45 days prior to the effective date to calculate the size of the adjustment. So borrowers should check the index value at that time to find out how large their change will be.

SOURCE: Bankrate.com data

SOURCE: Federal Housing Finance Board

The various indexes are available online and in newspapers such as The Wall Street Journal -- but homeowners need to know where to look. For example, many ARMs adjust to the weekly constant maturity yield on the 1-year Treasury bill, as calculated by the Fed. Borrowers can study the index's historical performance at the Fed Web site. Or, they can track its changes every week by going here, clicking on the latest release, scrolling down to the "U.S. government securities" section, locating the "Treasury constant maturities" header and finding the "Week Ending (Month/Day)" value listed for the one-year bill. It was 6.28 percent in the week ended May 26.

Start preparing NOW
Once they've determined what's coming, ARM holders need to prepare. If the first adjustment won't be for a long time, they should start socking away part of the money they're saving each month by avoiding a fixed rate loan. There's no way to know for sure if rates will be higher one or two years down the road, but that extra $50 or $75 a

month gives borrowers a cushion to draw upon if they are. The more time before an adjustment, the more money a borrower can save, but even people a few months away from a rate change can see some benefit.

"They shouldn't be caught by surprise," says Frank Nothaft, deputy chief economist at Freddie Mac. The McLean, Va.-based company buys loans from lenders, bundles them together and sells them as securities to investment firms.

"The reason they chose the ARM initially was because of the lower payments relative to a fixed rate loan," he adds. "Presumably, they're able to sock a little more into savings because they're enjoying the lower payments."

Borrowers who do stockpile some money will find they can take advantage of the way ARMs work to lessen the impact of a rate increase, too. Consider that prepayments on a fixed rate mortgage reduce the principal balance, loan term and overall interest bill, but not the monthly payment. With ARMs, the payment is recalculated each year along with the rate. As long as someone prepays at least 45 days prior to the effective adjustment date, the lender will use the reduced balance figure to establish next year's payment. That reduces the impact of the concurrent rate increase.

Of course, borrowers should look at their broader financial condition before prepaying. Rates on other consumer debt products, such as credit cards, are rising along with ARM rates. Because those rates are higher and plastic doesn't offer tax-deductible interest, someone with large card balances should focus on paying them off first.

"Before they get too concerned about the rate adjustment on their mortgage, they may want to look at other debt they have outstanding," says Chase's Gotsch. The mortgage debt "may not be the first debt they need to restructure."

Hybrid ARMS really get squeezed
Budgeting and preparation becomes even more important for borrowers who took out hybrid ARMs in the last couple of years. Consider that all ARMs have caps that prevent their rates from increasing more than a certain amount each year and over the life of the loan. A typical ARM rate can't jump by more than 2 percentage points a year or 6 percentage points over the full term. But the annual cap doesn't apply to the first adjustment on most hybrid ARMs, only the ones thereafter. That means borrowers who took out 3/1 ARMs just under three years ago or 5/1 ARMs before that should start paring back spending at the mall -- now.

"The first adjustment, in many cases, can adjust up to the lifetime cap, not the annual cap," says Blackwell of Washington Mutual. "Conceivably, you could have a 3/1 with a 6 percent rate that could adjust to something like 9 percent."

Borrowers who've had enough of the adjusting business can convert to a fixed rate mortgage in a couple of ways. One choice available mostly to 1-year ARM borrowers is a conversion option. It allows a customer to convert to a fixed rate, fixed payment schedule for a nominal fee. The $250 or $500 charge is much less than the couple of thousand required in a standard refinance.

Yet experts say conversion options don't make much sense unless the borrower doesn't have enough cash lying around for a new loan. That's because options typically dump ARM holders into loans with rates that are three-eighths of a percentage point to three-quarters of a percentage point higher than rates available in the marketplace.

"If you dig deeper below the surface, typically you'll find the rate the loan converts to is higher than if you were to go out and refinance on the open market," says Blackwell.

But even refinancing may not be wise right now. Many economists expect the Fed will succeed in slowing the economy without driving rates much higher. If they do, mortgage rates probably won't rise much further in 2000 and may even start falling by the end of the year.

"The perception right now is that rates are rising temporarily in order to eliminate some problems and that once the problems are eliminated, we're going to be able to move further along," says GSU's Ratajczak.

Then again, hardly anyone expected to see 30-year fixed rates approaching 9 percent this summer. That's why ARM borrowers should prepare for the worst even as they're hoping for the best.

"Families certainly should consider what will be happening with interest rates," says Nothaft of Freddie Mac. "A very safe and simple thing to do is assume a worst-case scenario and make sure you're comfortable with it."