Tough Times for Some Mortgage Holders

It is becoming increasingly obvious that financial advisers, real estate experts and parents will someday point to what is happening in the mortgage market today and use it as a cautionary tale of what can go wrong when a buyer stretches to get too much house during a market that seems invincible.

Real estate has been booming in most markets over the last five years or longer, fueled by interest rates that reached four-decade lows and by consumers who used new mortgage products to extend their buying power. Many home buyers stopped worrying about buying a home and instead worried about their ability to pay for one; rather than shopping for a deal that allowed for a lifetime purchase, they looked for a mortgage that allowed them to buy the most home for the lowest current payment.

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So long as rates stayed low and housing prices continued to move up strongly, that strategy was a good one. And those things kept happening, so that homebuyers ignored the warnings issued by many mortgage experts about what would happen when times changed.

Well, times have changed.

The popularity of adjustable-rate mortgages means that nearly 25 percent of all outstanding U.S. mortgage debt is due for an interest-rate reset within the next two years, according to, a Web site run by Moody's Corp. Some $400 billion in loans will get a new rate this year, and another $2 trillion are set to move in 2007.

Those moves won't be pretty. Just two years ago, the prime rate stood around 4 percent; today, it is more than twice that. As a result, payments on some ARMs will double too. The current forecasts from a number of experts have defaults on those loans increasing by 10 percent.

"There is no apples-to-apples comparison from the kind of mortgage someone could get a year ago and what they can get today," said Anthony Hsieh, president of "As rates rise on adjustables, there are steps people can take to reduce the sticker shock, but they're probably not going to be too happy with what they have to swallow now. ... They had a 42-year low in mortgage rates, but they were more concerned with how much they would have to pay each month than how much they could afford and buy a home reasonably."

Plenty of bad news

For someone who purchased a home using an ARM — or taking advantage of some of the attractive teaser rates that were available over the last few years — there is plenty of bad news if they need to refinance now.

Obviously, that starts with current interest rates. Moving to a 30-year fixed-rate mortgage now means looking at rates north of 6.5 percent, and the longer a consumer waits, the bloodier that transition is likely to be.

But if the house was purchased recently — and with the ARM keeping payments low — there hasn't been much equity build-up; if the home is in a market that is now cooling down, the owner's equity is further impaired.

"People were gambling that their income would get to a point where it was high enough to pay for the home at some point," says Greg McBride, senior editor at "They also were gambling that the market would help them build enough equity that they could refinance if they needed to. Now they may need to, and those gambles aren't paying off."

Some of those consumers will become default statistics. Others will have to downsize, or change neighborhoods, in order to get a mortgage that is more affordable.

There's a problem with that "smaller house" strategy too, at least in markets where prices are on the decline. A homeowner who put little down and who built little equity — and who lives in a market where prices are on the decline — may find that a small step back is not sufficient to actually cut mortgage payments.

How bad is it?

McBride suggests that consumers who are facing adjustable-rate sticker shock should try to determine now just how bad the movement might be. From there, they can decide if it's time to make a change so that they don't get slammed.

Many adjustable-rate mortgages include annual and lifetime caps on the interest rate that can be charged, so homeowners may not see the full impact of sharply higher rates immediately. A 2-percentage-point annual cap is fairly common.

To see how bad an adjustment hit might be, consumers should look at their mortgage paperwork to see when the reset occurs, the rate that the mortgage is tied to and then the margin that is used for the adjustment.

The Libor rate, for example, has moved from roughly 4.2 percent a year ago to about 5.6 percent today. A mortgage that is pegged to Libor plus two percentage points, therefore, will adjust up to about 7.6 percent.

A homeowner looking at that kind of rate could refinance into an average fixed-rate deal and be better off.

Says McBride: "There is still time to get off the tracks before the train gets closer, but people need to act now. A 7 percent mortgage today beats an 8 percent refi a few months from now.

"People's choices are only going to get uglier, and plenty of people are on their way to trouble. ... For everyone who has avoided this trouble, they're going to look back someday — when their kids are looking for a mortgage and are tempted to stretch too far by using an ARM — and have stories to tell about how they saw a time when everything that could go wrong with that strategy did go wrong."

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Copyright (c) 2006 MarketWatch, Inc.