Are we Headed for an ARM Train Wreck?

There is a potential train wreck on the financial horizon, one that’s not on many people’s radar. It’s the date when homeowners who have ARM’s, Adjustable Rate Mortgages of one kind or another, are going to face payment shock. Current estimates are that over one trillion dollars of Option ARMs and 3/1 or 5/1 ARMs done during the period of low interest rates are going to adjust soon. They will go from the low initial rate to as high as 8%. That means a huge payment increases for those borrowers.

Some pundits say that this will cause a massive increase in the number of foreclosures. My guess is that with higher mortgage payments, cash-strapped consumers will not have as much money to buy other things. That negatively affects consumer spending, the engine of this economy. Maybe, maybe not, but all those homeowners need a wake-up call. How might this affect them?

Most such ARMs are tied either to the 1 year Constant Maturity T-Bill index or LIBOR. The T-Bill index is 4.99% and 6 month LIBOR is 5.38%. Add the typical margin and you get “real rates” between 7.6% and 7.8%. Whoa! What does this mean in terms of payment?

Let's say someone got a $400,000 loan a few years ago at 4.5%. The initial payment on that loan would have been $2,027. Now, after 5 years, the loan would have been paid down to $364,632. At a new interest rate of 7.75% amortized over the remaining 25 years, the new payment would be $2,754, a 36% increase. Some loans, but certainly not all, cap the first adjustment at 2%, so the new rate for one year would be 6.5% with a payment of $2,462, a 21% increase. But a year later it would jump again, perhaps even higher than $2,754.

The so-called Option ARMs, the negative-amortization loans, looked even more attractive to tens of millions of people, the not-too-smart choice of as many as 40% of recent homebuyers. The payment might be based upon a start-rate as low as of 1.5%, perhaps even lower. The payment on that loan is only $1,380, a lot less than more sensible alternatives.

Note that the real interest rate on these loans is already above 7%. The payment just hasn’t caught up yet. When it does, borrowers will see payments more than double. If they had trouble qualifying when they got the loan, which is likely, how are they going to afford a payment that is over twice as high?

Luckily for people in this market, even those who made little or no down payment have seen their homes appreciate enough to allow them to refinance into a more sensible program. Still others will see that they will be in trouble payment-wise but have enough equity so they can sell their homes and bail themselves out of the trouble. But of course, they don’t own a home any more in this scenario.

There are others who simply could not afford the home, but some irresponsible real estate agent and conspiratorial loan officer figured out that they could make it work, so they sold them a home. In these cases, someone will have to pay the piper, and in some cases it will be sooner rather than later.

The concern that I have is that many if not most borrowers who have these loans are oblivious to the train wreck that they may be headed for. They just do not look at the facts that are right in front of them. Let me give you another example. In the 1980's, borrowers had a choice of three indexes to which to tie their loan's rate. The overwhelming majority chose the wrong one, the one that was the highest profit loan for the lender. Fast forward to the 21st Century. The Federal Reserve has increased rates seventeen times. Yet with all this clear evidence that rates were increasing, tens of millions signed up for volatile ARM’s and exposed themselves to significant rate risk.

Bottom line: looking at history, it’s hard to be optimistic that consumers are any better equipped to make sound decisions here either. But if we all spread the word, many will start to correct their situations now, and not wait until it's too late.

The good news is that those who have been giving people better advice all along - like me, hopefully - will be able to come to the rescue and get these people back on a more sensible track. I hope that you'll help spread the word and ask them to call me.