Candidate For Rate Shock? Some Suggestions, Maybe Some Comfort

Now that the housing bubble has officially started to deflate we can turn our worries to the newest wiggle: Rate Shock.

At least three of the major television and cable networks have run stories in the past week about the danger confronting homeowners with adjustable rate mortgages when those rates adjust. Experts estimate that 25 percent of all loans are adjustable rate mortgages and billions of dollars worth of these will adjust in the next year. Because of compounding factors such as rising energy costs, static wages, and a softening housing market, these adjustments may just price many people out of their own homes.

Exacerbating the problem of rising mortgage rates and falling property values are what the Association of Community Organizations for Reform Now (ACORN) calls "layered risk loans". As we reported in an earlier article about a study conducted by this group, some homeowners who have opted for ARMS have also further cut payments by choosing "interest only" or optional payment types of these loans. Both of these have the possibility of greatly reducing the amount of equity that has been built and the optional payment can even result in a higher principal balance than the original loan.

If you are in this position, with a mortgage that will be adjusting (or maybe recently has) and especially since rates are now down a bit from recent highs, it is time to evaluate your position and make a decision whether refinancing your mortgage or mortgages makes sense or is even possible.

Can you refinance?

The shear ability to refinance into a fixed rate mortgage or even an ARM with longer term stability may be the determining factor for many people. If a home was in an area without the phenomenal run-up in value that was seen in many places or if a homeowner has repeatedly refinanced in order to draw out funds for bill consolidation, home improvements, or financing lifestyle choices, the equity may simply not be there to allow refinancing. Lenders are not, at this time, banking on future home value appreciation to fudge borderline loans.

Homeowners who are already in trouble from rising rates or other financial problems may also be unable to secure reasonable refinancing. An existing mortgage delinquency or a pattern of recent late payments on other bills will make a new mortgage at market rates virtually impossible.

Should you refinance?

There are a multitude of variables that will determine whether a refinance is a reasonable solution. First of all, do you know the parameters of your mortgage note?

The ACORN study reported that a large number of people with ARMs have no clear idea about the terms of their mortgage. Will it adjust? When is the adjustment? How is the adjustment determined? And most important, what is the bottom line, i.e. the size of the check you will have to write after the rate adjusts?

Look at your mortgage note. You were given a copy at closing and it contains all of the terms regarding this adjustment. It will give the initial mortgage rate and the date and frequency of any adjustments It will also give the basis (or index) upon which the new rate will be determined and the margin i.e., the additional amount that will be added on to the index. Some of the more common indexes are the LIBOR (see below), the monthly average yield on three year treasury securities or the 52 Week Treasury Note. The current LIBOR indices can be found at www.fanniemae.com/newsreleases and many other treasury indices can be found at http://www.indymacb2b.com/news/currentIndices or in most of the larger daily newspapers and the Wall Street Journal.

For example, your mortgage may be pegged to the 6 month London Interbank Offered Rate (the LIBOR) which this week was at 5.43130 percent. If your margin is 2.75 percent, your new rate will be 8.18 percent. Next, use a rate calculator such as the one on this website and enter your current principal balance, the new rate, and the number of years (or months) remaining on your mortgage. Example: a balance of $135,000 for 29 years. The resulting number, $1,015.76 will be your new mortgage payment, not including any required escrows for property taxes, insurance, or private mortgage insurance.

If you hair is now standing on end, relax. Most prime mortgages have rate caps. These go along way in muting the effect of the adjustment. Caps are usually expressed as 1/5, 2/6, etc., which means that the rate cannot increase more than the first number - one or two percent - in any one adjustment or by any more than the second number - five or six percent - over the life of the loan. Thus, in the LIBOR example above, if your loan originated in October, 2005 when the average rate was 4.51 percent and has a 2/6 cap your rate cannot shoot up to 8.18 percent but only to 6.51 percent because of that cap. This would result in a new payment of $863.82 using the example above. During the entire 30 year term of the mortgage your rate can never be higher than 10.51 percent because of the 6 percent lifetime cap. These caps, however, also mean that, should rates drop over the next few years, you can benefit only to the extent of the caps which limit the decreases in the same measure that they limit the increases.

Some caveats.

Lenders have been offering "teaser rates" on ARMs for years but this promotion has been particularly notable in the last year as rates moved up from historically low levels. With a discount or teaser the loan is discounted from the going rate for an initial loan period to make an ARM more attractive. These teaser rates react in different ways but be aware that they will always return to the index rate plus the margin - in other words, what they ordinarily would have been. One example: the introductory or teaser rate started at 4.0% interest and would adjust upward 1.0% every six months. If your index for this loan was 5.0% and the lenders margin was 3.0%, then the interest on your loan for the first six months would be 4.0%. Six months later, it would increase to 5.0% and so on until the fully-indexed rate was reached. To find the fully-indexed rate, you would add the index to the margin (5.0% + 3.0%). After the fully-indexed rate was reached, your loan would then fluctuate with the index on your loan. In another example, an initial rate of 5 percent is discounted to 4.5 percent. At the adjustment the new rate would be calculated from the real rather than the discounted rate which would override any cap. In other words, if the newly calculated rate is 7.5 percent and the cap is 2 percent the rate would wind up at 7 percent rather than 6.5 percent. If this is making your eyes cross, contact your original lender for an explanation.

A second warning when evaluating your current loan: there are a few sub-prime loans floating around that have some bizarre conditions. One variety, for example, will only adjust upwards. If rates go up you pay more but if they go down you do not benefit. There are also mortgages out there with only one type of cap - an adjustment cap which controls a single increase or a lifetime cap. Thus, your rate could increase every year forever (or until it hits your states maximum usury level) or it could take a single mega-jump up to the lifetime cap. Still other variations include a longer static period - perhaps two or three years, followed by frequent adjustments such as every six months for the life of your loan. Again, read your note!

Now that you have a better idea of what the future holds, you do have a few options and we will talk about some of these in an upcoming article.