Some consumers will be in for a rude shock, says David Kotok, of Cumberland Advisors in Vineland, N.J. Some $1 trillion in low-interest mortgages will re-set at a higher interest rate in 2007 and another $1 trillion in 2008. “About 4 million to 5 million households will be negatively impacted,” he estimates. “This is mainly people in the lower and middle class, the Wal-Mart shopper, not the Tiffany shopper.” US ’07 economic outlook: slow growth, no recession, Christian Science Monitor, December 29, 2006.
For the past year or so news reports have been filled with stories, articles and columns about the huge number of adjustable rate mortgages that are now transforming from low-cost “start” levels to loans with far more expensive monthly payments — and that vast numbers of foreclosures are sure to follow.
Are these predictions real? Are millions of homes really at risk?
Unfortunately, there’s evidence to show that such predictions are well within the range of reason.
With many ARM, option ARM and interest-only loans there’s an initial “start” period which features low monthly payments and often low monthly interest levels as well. With some loans, payments made during the start period cover all interest costs; however with many mortgages those low start-rate payments do not even cover interest costs.
As an example, imagine a $200,000 mortgage where the interest rate is 7.25 percent but monthly payments for interest during the start period are just $650. After a year, interest would amount to $14,500 — but payments to the lender total just $7,800. In this illustration, interest worth $6,700 ($14,500 minus $7,800) would be unpaid and added to the loan balance. Unpaid interest added to the mortgage debt is called “negative amortization.”
Now imagine that the start rate continues for five years. In general terms if our borrower just paid $650 a month then at the end of the start period the loan balance would have increased in size by more than $33,500.
If we say that the interest rate has never changed, that it remains at 7.25 percent at the start of the sixth year, then when the loan “re-sets” the borrower owes at least $233,500 which must be repaid over the 25 remaining years of the loan term. The monthly cost for principal and interest? $1,446 — more than double the minimum monthly payments in the first five years.
Of course, there’s no guarantee that interest rates won’t rise. As well, the real principal balance would be higher than shown in our illustration because each month the debt grew and so did accumulated interest costs.
“For some borrowers the new and higher costs after low-cost start periods won’t be a problem,” said James J. Saccacio, chairman and CEO at RealtyTrac, the nation’s leading foreclosure marketplace. “They will have the income to make the monthly payments. Alternatively, some borrowers will have sold the property before the loan re-sets or they will have refinanced to a loan with lower monthly costs.
“But the grim reality is that some borrowers won’t be able to afford the higher monthly costs, some will be unable to sell because local market values have stalled and others will not have sufficient credit or equity to refinance. Such borrowers, unfortunately, are prime candidates to be foreclosed.”
In February 2006, Christopher L. Cagan, Director of Research and Analytics at First American Real Estate Solutions, a company which maintains transaction data for more than 100 million properties, issued a report which first mentioned the trillion-dollar re-set liability facing American homeowners.
The Cagan study — Mortgage Payment Reset: The Rumor and the Reality — looks at the 7.7 million adjustable first mortgages issued in 2004 and 2005. Cagan divided these adjustable mortgage products — loans worth $1.9 trillion — into three categories:
- Category 1: Loans with near-market rates were regarded as having little foreclosure risk. The reason? When rates re-set borrowers are likely to face only small payment increases and maybe none at all.
- Category 2: Loans with high initial rates. “Many, but not nearly all, of these loans are at risk due to payment re-set,” say Cagan. These mortgages have a significant level of risk because the high initial rates suggest that such loans were made to borrowers with low credit scores and modest incomes. If monthly costs go up, these borrowers may have a limited ability to make their payments.
- Category 3: Those who borrowed with initial teaser rates below 4 percent. When these loans finally adjust to fully amortizing market-rate levels, Cagan says “the payments will have increased by more than 50 percent from their initial amounts. Often the payments will have doubled, or more than doubled.” In other words, these are the borrowers most likely to have re-set worries.
By Cagan’s count, of the 7.7 million ARM products originated in 2004 and 2005, some 3 million with a face value of $768 billion will face some re-set difficulties. Most borrowers will be able to handle higher costs. However, mortgages worth an estimated $297 billion are likely to wind up in foreclosure.
The foreclosure rate for ARMs projected by Cagan is substantially higher than foreclosure rates generally. In dollar terms he says that better than one adjustable loan in six is likely to fail, or about 15.6 percent ($297 billion out of a total of $1.9 trillion).
In comparison the Mortgage Bankers Association says roughly one loan in 100 (1.05 percent) is in the foreclosure “process” at anytime. However, not all of these homes will actually be foreclosed because borrowers are able to bring mortgages current, refinance, modify loan arrangements with lenders or sell the property. In effect, the final foreclosure rate is significantly below 1 percent.
Cagan made his predictions last February and with 2006 finished we can see how his initial estimates are turning out.
First, foreclosure activity has risen substantially. According to RealtyTrac, foreclosures nationwide rose 42 percent in 2006. In total, nearly 1.3 million homeowners faced foreclosure last year, up from 885,000 borrowers in 2005.
Second, not all foreclosures are related to ARM re-sets. As in most years, many foreclosures are caused by such typical difficulties as divorce, accidents, job loss and similar problems. Also, it’s not just ARM borrowers who lose their homes. Borrowers with fixed-rate mortgages can also face foreclosure. The distinction is that fixed-rate borrowers never face re-sets and higher monthly payments for principal and interest.
Third, if typical difficulties are generally constant year after year, then the higher monthly costs associated with mortgage re-sets are at least partially responsible for steeper foreclosure rates.
“Over the next few years several million homeowners will be foreclosed,” Saccacio said. “Many owners will lose their homes, but many owners can avoid foreclosure by acting now. Because rates are low at this time, those who face steeper mortgage payments in the near future should consider refinancing with today’s fixed rates. This is the one sure way to defeat mortgage re-sets and the financial disasters they can produce.”
Peter G. Miller is the author of the Common-Sense Mortgage and is syndicated in more than 90 newspapers.