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A Look Ahead To the Great Resetting

By Dina ElBoghdady
Washington Post Staff Writer
Saturday, October 3, 2009

Take a look around the corner.

Millions of adjustable-rate mortgages are going to reset in the coming years, possibly to higher interest rates, creating the prospect of a new round of foreclosures.

About 10 percent of all mortgages in this country are scheduled to adjust in the next few years, with the numbers peaking in mid- to late 2011, according to First American CoreLogic. Those loans are worth about $1 trillion, and nearly 20 percent of the borrowers who have them are already seriously behind on their monthly payments.

Many of these loans will lapse into foreclosure and disappear before they adjust, said Sam Khater, senior economist at First American CoreLogic. Others will terminate for less dramatic reasons as people sell their homes, refinance or have their mortgages modified.

"I suspect that at least a third of these [adjustable loans] won't be around by the time they are scheduled to reset," Khater said.

Traditional adjustable loans made to prime borrowers generally carry lower rates than similar 30-year, fixed-rate mortgages written at the same time. They became popular in the 1980s, when interest rates soared and few could afford to commit to fixed-rate mortgages. They had another burst of popularity in recent years when lenders aggressively marketed them with artificially low teaser rates as housing costs climbed and home buyers stretched for any savings they could find.

During the recent boom, these loans attracted millions of subprime borrowers, typically people with poor credit. But the subprime market unraveled when home prices started to soften and loans started to adjust. Some subprime borrowers saw their interest rates surge and their monthly payments more than double. They could not refinance or sell because, with prices down, they suddenly owed more than their homes were worth.

Foreclosures have just about wiped the subprime loans out of the market. But now, other types of loans are about to adjust.

Some of them won't necessarily adjust upward. Rates on adjustable loans can also go down. And they probably will over the next year for borrowers with traditional prime loans because rates are at historic lows, said Guy Cecala, publisher of Inside Mortgage Finance.

"We have a long way to go before prime borrowers see a big jump in payments," Cecala said. "It's not something people are predicting for 2010. We're looking at 2011 and 2012. None of us know what's going to happen then, but we're assuming rates will rise."

When they do, some borrowers could be caught off guard, said Greg McBride, senior financial analyst at Bankrate.com, a personal finance Web site.

"We've seen this movie before," McBride said. "We know that interest rates are going to go up, and go up a lot, at some point in the next several years. You don't want to be holding an adjustable-rate mortgage when that happens."

The most vulnerable borrowers will be those with "option" ARMs, which tend to be concentrated in places, like California, where home prices soared then plunged precipitously.

Option ARMs, also called pick-a-pay mortgages, allow borrowers to choose how much to pay each month. Nearly all borrowers who took out these loans from 2004 to 2007 chose to pay less than the interest due, and the unpaid interest was tacked on to the balance. Eventually, these borrowers will have to pay the principal and all the unpaid interest, creating payment shock.

For them, loan balances are rising at a time when home values are falling, said Keith Gumbinger, a vice president at the mortgage research firm HSH Associates. "They've got bigger problems than just the interest rates."

Another group of borrowers closely tracked by analysts are those with Alt-A loans, so called because they are an alternative to prime (or A) mortgages. Those loans initially catered to financially sophisticated borrowers with strong credit scores and hefty down payments who would not or could not document their income or assets. They were popular among people who were self-employed or whose income fluctuated.

Increasingly, Alt-A loans came to be known as "liar loans" because so many lenders and borrowers did not provide accurate income data. Now, with unemployment rising, it's unclear whether many of those borrowers can afford their current mortgages, let alone higher payments should their rates jump.

But these types of mortgages, and adjustable loans in general, are "not evil," Gumbinger said. Originally, they were niche products targeted at creditworthy borrowers, and they performed well for decades. "But there are certain audiences for which these loans are not and never will be a prescription for success," he said.

These loans have been appealing, though, because they offer lower payments -- at least for a while.

The higher interest on fixed-rate loans reflects the added risk such loans pose for lenders.

With fixed loans, lenders bear the risk of financing a mortgage that borrowers can keep for the long term if rates rise but refinance without penalty if rates go down. With adjustable loans, borrowers bear the risk of rates going up; lenders entice them to accept that risk by offering lower introductory rates.

But the interest rate gap between the two has narrowed dramatically in recent months, which is why many consumer advocates say fixed-rate loans are now a sensible choice for most borrowers.

The average rate on a 30-year fixed-rate loan was 4.94 percent in the week ending Oct. 1, the lowest in four months, according to the most recent Freddie Mac survey. For loans that are fixed for five years and adjust every year thereafter, the average rate was 4.42 percent.

Consumers seem to be getting the message. Applications for adjustable loans peaked at 36 percent at the height of the housing boom in early 2005, according to the Mortgage Bankers Association. Now, they are close to 6 percent.

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