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2006: A look back - A look ahead  
  Mortgage rates and home prices rose in 2006 while a refi boom is anticipated in 2007.
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Some ARM borrowers will refi in 2007

2007 will bring an unusual refinancing boom as hundreds of thousands of borrowers bail out of their adjustable-rate mortgages while the getting is good.

On top of that, sellers and buyers will grapple with stagnant or falling house prices in some markets. And it's anyone's guess what course the Federal Reserve will take.

Like the twin strands in a DNA helix, house prices are intertwined with the fate of adjustable-rate mortgages, or ARMs. That's especially true for two types of adjustables: interest-only mortgages and a subset called pay-option ARMs. The main appeal of these nontraditional mortgages is that they have extra-low monthly payments, allowing people to buy more house than they otherwise could afford. That benefit brings a trade-off: borrowers build up equity slowly or, in some cases, actually lose equity in the house with every monthly payment.

In a self-reinforcing cycle, rapidly rising house prices pushed buyers into getting pay-option and interest-only ARMs, while the popularity of these loans sent house prices even higher. Definitive estimates of the popularity of nontraditional mortgages are hard to come by, but it is believed that in some markets, especially in coastal California, around half or even more of new home buyers took out interest-only or pay-option ARMs in 2005 and 2006.

Although nontraditional mortgages start out with low monthly payments, they are sensitive to rising interest rates. A pay-option ARM might have an initial rate of 1.9 percent that lasts only a month. The rate can rise every month thereafter and could exceed 7 percent within six or seven months. The sneaky thing about pay-option ARMs is that, although the rate might rise every month, the minimum monthly payment doesn't. The minimum monthly payment changes just once a year. That means that the minimum payment often doesn't even cover the interest charged, so that the loan balance rises.

Expecting to pay off a mortgage that way is like eating a dozen doughnuts every morning and expecting to lose weight by walking a mile every evening.

Mortgage bankers believe a steady influx of homeowners will refinance their nontraditional mortgages into something less exotic in 2007. A lot of them will refinance into 30-year, fixed-rate mortgages. Others will get hybrid ARMs, such as the 5/1 ARM, which has a relatively low introductory rate that lasts for five years, then adjusts annually thereafter. Hybrid ARMs are popular among people who expect to sell their houses within a few years.

-- Posted: Nov. 1, 2006
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