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PERSONAL FINANCE

With ARMs, Rising Rates Pose Risks for the Unwary

August 24, 2003|Kathy M. Kristof | Times Staff Writer

Adjustable-rate mortgages are making a comeback in response to a steep rise in the cost of fixed-rate loans.

But industry experts worry that borrowers who have enjoyed a long period of declining interest rates may be unaware of how risky adjustable loans can be in a rising rate environment.

"The consumer, in his quest to get in a new home, is likely to gravitate to the cheapest product," said Angelo Mozilo, chief executive of mortgage lender Countrywide Financial Corp. in Calabasas. "But they need to have the lender provide the maximum amount of disclosure on an adjustable loan to make an intelligent decision about whether they can afford the home if interest rates rise."

The appeal of adjustable loans is that their initial interest rates, and monthly payments, are significantly lower than those of fixed-rate loans. Where the average rate for a 30-year fixed loan was 6.22% last week, the average rate for an adjustable loan was 3.49%, according to the Mortgage Bankers Assn. in Washington.

On a $200,000 loan, those rates work out to a monthly payment of about $1,227 for the fixed-rate loan versus $897 for the adjustable.

No wonder more home buyers are turning to adjustables, considering the surge in fixed-rate loan costs from less than 5.25% in mid-June. In July, adjustables -- also known as ARMs -- accounted for 26% of the dollar volume of total mortgage applications, the Mortgage Bankers Assn. says. That was the highest percentage in a year.

In other periods of rising interest rates, such as in 1999, ARM loans have accounted for more than 40% of all loans.

The catch today is that the lower rates on ARM loans probably are temporary.

From mid-2000 to mid-June of this year, adjustable-rate borrowers benefited from a steady decline in market interest rates. But if the economy continues to recover, current ARM borrowers face the strong possibility that market rates will rise further, pushing their payments higher as soon as the loans' first adjustment date, said Keith Gumbinger, vice president at Butler, N.J.-based loan research firm HSH Associates.

What's more, because of the way some ARM loans are structured, their rates could rise even if market rates stabilize near current levels, experts warn.

How soon rate adjustments could occur, and high ARM loan rates could go, would depend on the type of loan and on market interest rate trends.

Borrowers need to carefully consider six key elements of an ARM, Gumbinger said, to make sure that they can handle the risks:

* Adjustment periods. The day of reckoning with an ARM generally is the first adjustment date. That's when the rate on the loan can move from the initial offered rate to either the "fully indexed" rate or the "rate cap," whichever is less. (More on indexes and rate caps later.)

How quickly this day comes can vary widely. Some adjustable loans offer only one month's respite from interest rate hikes, whereas so-called hybrid adjustables can offer up to 10 years of a fixed rate before the first adjustment. After that first adjustment, hybrid loans usually adjust their rates once a year.

In times of declining market interest rates, the best ARM loan deals are those that adjust frequently, such as the monthly adjustables offered by many big savings and loans, said Jay Brinkmann, vice president for research and economics at the Mortgage Bankers Assn.

In today's rising-rate environment, however, more home buyers are likely to favor ARMs that offer a fixed rate for years rather than months.

But ARMs that offer longer fixed-rate periods also are more costly. Countrywide, for example, last week was charging 3.25% on ARMs that adjust once a year, while its rate was 5.5% for loans that offered a five-year fixed-rate period before the first adjustment.

* Index and "margin." The fully phased-in interest rate on an ARM is calculated by adding a "margin" -- a set number of percentage points -- to an index. The most commonly used ARM indexes are the London InterBank Offered Rate, or LIBOR (a measure of banks' short-term funding costs), and the one-year U.S. Treasury bill interest rate.

The benefit of the T-bill index is that it's somewhat less volatile than the LIBOR rate, Brinkmann said. But as a result, most banks charge a bigger margin on T-bill-based loans.

Typically, adjustables will be priced at the LIBOR rate plus 2.25% or the T-bill rate plus 2.75%, he said.

All lenders have historical data on the movements of these indexes for borrowers to review on request, Mozilo said. That should give a borrower a fair idea of how the rates on various loans might change over time.

Because the indexes are short-term interest rates, their moves depend in large part on the Federal Reserve, which controls U.S. short rates.

For now, the Fed is pledging to keep short rates at current 45-year lows, which is a help to ARM borrowers. But if the economy continues to recover, many experts believe the Fed will start raising rates sometime in 2004.

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