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May 24th, 2011

Is now the time to dump your ARM?

by Peter Miller


Ticking money bombDespite continuing low mortgage rates, one prominent Detroit bankruptcy attorney says ARMs remain a looming danger and should be avoided.

“The problem is that a significant part of our housing is still mortgaged with ARMs,” said Michael A. Greiner, a bankruptcy specialist. “Interest rates have been at historic lows for years now. But we are already starting to see upward pressure on interest rates. Once interest rates start to rise again, ARM payments will start to rise again.”

Greiner explained that “The ARMs are what originally caused this crisis. People were unable to afford their mortgage payments when the rates adjusted…and that is what started the foreclosures. Since then, the foreclosure crisis has been driven by the larger economy, not by the ARMs adjusting. But when interest rates start rising again, we will see another wave of foreclosures due to the ARMs going up again.”

ARM trends

Greiner, of course, is right that if rates rise, a lot of marginal ARM borrowers–individuals who cannot afford steeper monthly costs–could face foreclosure and bankruptcy. That said, borrowers have been dumping ARMs recently:

Eighty-four percent of borrowers who had a hybrid ARM chose to refinance into a fixed-rate product during the first quarter, continuing a pattern of the past few years of borrowers revealing a strong preference for fixed-rate over variable-pay contracts.

During the first quarter of 2011, the ARM share of applications was 6 percent in Freddie Mac’s monthly ARM survey, which includes purchase-money as well as refinance applications.

The ARM issue may be overblown

Even if ARM rates were to rise, I think the problem they present may be overblown. I do not agree with the idea that “ARMs are what originally caused this crisis.”

Instead, let’s be more specific: what set off the mortgage meltdown was the creation of “affordable” loan products, many of which looked like ARMs but were radically different and more dangerous forms of financing.

Option ARMs: the evil twin

To give an example, since the 1970s, ARMs have generally had two forms of interest rate caps–an annual cap and a lifetime cap. Interest rate increases were typically limited to 2 percent per year, with a 6 percent cap over the original rate of the loan.

However, in 2002 and 2003 we began to see the “option ARM” concept emerge–a product under various names which allowed borrowers to make several payment choices during the loan’s start period. This loan also was distinguished by the fact that it often had three payment caps–a 2 percent annual limit, a 6 percent lifetime limit and a 6 percent limit when the loan was re-cast.

In other words, with this third payment cap, an option ARM rate could increase by as much as 6 percent at one time.

We knew Option ARMs were bad news

This problem was not unknown to the lending industry. Six years ago, John Dugan, the Comptroller of the Currency and a major bank regulator, explained the dangers:

In the case of a typical $360,000 payment option mortgage that starts at 6 percent interest, monthly payments could increase by 50 percent in the sixth year if interest rates do not change. If rates jump two percentage points, to 8 percent, monthly payments could double.

“Is this an appropriate product to mass market to customers who may be looking at the less than fully amortizing minimum payment as the only way to afford a larger mortgage–at least for the five years before the onset of payment shock?” Mr. Dugan asked. “And are lenders really prepared to deal with the consequences–including litigation risk–of providing such products in markets where real estate prices soften or decline, or where interest rates substantially increase?”

“Too many consumers have been attracted to products by the seductive prospect of low minimum payments that delay the day of reckoning, but often make ultimate repayment of growing principal far more difficult,” he added. “At the same time, too many lenders have been attracted to the product by the prospect of booking immediate revenue without receiving cash in hand, a process that often masks underlying credit problems that could ultimately produce substantial losses.”

What should you do if you still have an option ARM?

The easy answer is to refinance or get a loan modification. However, if you’re underwater or behind on your monthly payments, getting approved for either is going to be extremely difficult.

What if you just have a plain ARM? If you do, take a look at the potential monthly payment increases to see if you’re able to meet them given your current budget. If not, seek some stability by refinancing into a fixed-rate product. If you’ve had your ARM for at least a few years, you may want to consider a fixed-rate loan with a shorter term, say 20 or 15 years, as opposed to a new 30-year loan.

Peter G. Miller is syndicated to more than 100 newspapers and operates the real estate news site, OurBroker.com.

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