Milwaukee Journal Sentinel, The: More gambling with ARMs as rates rise; Adjustable rates reduce

As mortgage rates rise from 30-year lows, a record number of Americans are financing home purchases with loans where the size of the future monthly payment is unknown.

Adjustable-rate mortgages, or ARMs, now have 36.6% of the market, an all-time high, the Mortgage Bankers Association reported Wednesday. Fixed-rate mortgages still dominate the loan industry, but no longer overwhelmingly so, the trade group's records show.

Home-price sticker shock has a lot to do with the increased popularity of the adjustable-rate loans, bankers association economist Michael Fratantoni said from his office in Washington, D.C.

"Housing prices went up an average 11 percent nationwide last year," Fratantoni said. "In many areas of the country, there's some concern about affordability. One way of increasing purchasing power is to move to adjustable-rate loans."

The catch: The initial lower interest rate on adjustable-rate loans doesn't last.

"You have a lower initial rate, but you also have exposure to varying rates over time higher rates," Fratantoni said.

Like most housing industry economists, he expects America will soon bid adieu to interest rates that have hovered at bargain- basement levels since the 2001 recession. As the economy gains strength, and the federal deficit swells, private borrowing costs are expected to rise steadily in the next few years.

That climb may be under way mortgage interest rates have climbed for six weeks straight. Mortgage bankers' latest weekly market report shows the average 1-year ARM interest rate at 4.39%, up from 4.12% last week. The interest rate for a standard 30-year fixed- rate mortgage is 6.08%, up from 5.95% last week.

That gap means a lot to borrowers. The nation's median home price hit $191,000 in February. On a $150,000 loan, monthly payments would be $750.26 with an adjustable loan or $907.06 for a fixed-rate loan, amortized over 30 years, according to Bankrate.com's mortgage calculator.

But the adjustable's low terms last only a year; afterward, that $750.26 monthly payment could go much higher.

Consumers know the short-term odds aren't good, so many opt for a compromise, hybrid adjustable-rate loan.

"Their rates are fixed for 3, 5, 7 or 10 years and then they adjust. Research indicates two-thirds or even three-quarters of the ARM market are hybrids," Fratantoni said.

Hybrids may be a wise choice, he said, "if you know with a fair amount of certainty you'll be in that home less than the fixed period."

Maybe an expensive gamble

Orawin Velz, senior economist at Fannie Mae, the nation's largest mortgage finance company, thinks some ARM borrowers are investors looking to cash in on rapidly appreciating local markets before low rates disappear. Others, hard-pressed to make home deals without these lower rates, are betting that their paychecks will grow enough to cover a higher payment.

These could prove expensive gambles, the economist said.

With a hybrid ARM, "you're buying more time 3, 5 or 7 years," she said. "But there is concern here because of payment shock. The effect on monthly payment can be much more than people anticipated."

Too many people think double-digit home appreciation rates will continue, and "we at Fannie Mae believe that level of appreciation is unsustainable," Velz said. "The majority of the country will see a 4 percent to 5 percent appreciation rate this year."

Some parts of the United States won't fare that well, the economist said.

"We will see some decline in some metropolitan areas areas with a lot of risk factors," she said. "Those are places with unusually high gains compared to history, a very high share of ARMs, a high investor market share and very low employment growth."

Even rapidly appreciating markets are safe if their run-up is supported by strong economies, rising income and tight supplies, she said. Such is the case in Washington, D.C., she said, but declined to name other "safe" markets.

Richard DeKaser, chief economist at National City Corp., a Cleveland-based financial services company, wasn't so reticent. The Milwaukee market is fairly valued and Madison is slightly undervalued, he said in a Feb. 11 analysis. That analysis found 16 mostly East and West Coast metro areas to be at least 20% overpriced and at risk for a downturn.

Some consumers already are trying to avoid the shock, said Dick Pas, president of Heartland Home Mortgage Co. Inc. in Hales Corners.

"They're trimming their sails," Pas said. "They're taking a look at their entire financial picture this mortgage, those credit cards, that home equity financing, maybe a car loan or boat loan. And some are refinancing to roll it all into the mortgage at a fixed rate."

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