Households with ARMs are currently feeling,
or will feel at the next adjustment, the effects of
rising interest rates through sharply higher mortgage
payments. The full effect of higher rates will be delayed
for households that are not facing the first rate adjustment
until 2007 or later. As a result, borrowers are moving
out of adjustable-rate mortgages and locking in fixed
rates that are currently lower than what their adjustable
rates will jump to at the next reset.
A common index for
adjustable-rate mortgages, the one-year Treasury, could
exceed 5 percent by the time the Fed is done raising
interest rates. Tack on a margin of 2.5 percentage points,
and the borrower is facing a rate of 7.5 percent, perhaps
more. For home buyers and existing homeowners alike,
fixed-rate mortgages will remain the popular choice
as long as fixed rates stay below 7 percent.
Of course, households expecting a sharp
increase in income -- upwardly mobile professionals
such as doctors, lawyers or small business owners --
may still opt for the adjustable mortgage route if increasing
income will offset higher mortgage payments. Not only
are these borrowers best-suited to handle any fluctuations
in monthly payments, but they could see payments fall
several years later if the Fed must begin reducing short-term
interest rates at some point.
The Fed is not done raising interest rates,
which means rates for home equity lines of credit are
still on the "up" escalator. The current rate
of 7.5 percent could hit, or exceed, 8 percent by the
time the Fed is done raising interest rates. This is
much more significant to existing HELOC borrowers that
accumulated the balance or initiated a piggyback loan
when interest rates were much lower, such as 4 percent.
In the meantime, the monthly payments have routinely
moved higher, and they now face having to repay the
balance at higher rates.
For borrowers looking to begin tapping
home equity in 2006, the outlook is much different.
With the Fed coming to an end of the rate hikes, presumably
in the first half of 2006, new HELOC borrowers may actually
benefit if interest rates fall below the current average
of 7.5 percent during the period their balance is outstanding.
Further rate hikes this year will have a limited impact
if borrowers have yet to accumulate significant balances
on their lines of credit.
Home equity loans, which offer fixed rates,
have been a popular destination for HELOC borrowers
looking to avoid interest-rate variability. But 2006
may be a different story. With the Fed close to wrapping
up the interest rate hikes, locking in a fixed-rate
home equity loan at the current average of 7.5 percent,
or a potentially higher rate later this year, may provide
only limited benefit by protecting the borrower from
rising rates. However the borrower will surrender the
ability to benefit if interest rates fall during the
If interest rates peak in the middle
of 2006 and don't rise further, the payment and borrowing
flexibility of a line of credit will remain attractive,
relative to a home equity loan where the interest rate
and monthly payment are carved in stone.