Economist's Commentary: April 14, 2008
Taking the Sting Out of Resetting ARMS
By Lawrence Yun, Chief Economist
The deep slashing of the interest rate by the Federal Reserve since the emergence of the credit crunch last August has only modestly lowered mortgage rates. The Fed funds rate has fallen from 6.25 percent to 2.25 percent over the past eight months. Over the same period the average 30-year fixed rate mortgage rate fell only lightly from 6.6 percent to about 5.8 percent while the 1-year adjustable rate mortgage (ARM) fell from 5.7 percent to 5.1 percent. The fall in mortgage rates, even though modest, is still a help. Without it, home sales would be trending even lower.
Though the Fed rate cuts have not greatly helped home buying, they have significantly lowered the cost burden of resetting ARMS. Ben Bernanke emphasized this point in his speech last week. At the height of the housing market boom in 2005, a significant number of people took 2-28 loans (2 year initial low interest rate, followed by 28 years of adjustable rate mortgages) and were experiencing severe payment shocks last year. In some cases, mortgage payments were more than doubling after the reset.
The terms of ARM resets vary widely depending upon individuals and lenders. But they generally follow the term of the INDEX rate plus a (profit) MARGIN. That is,
Newly resetting ARM rate = INDEX + MARGIN
The INDEX rate is essentially the cost of borrowing funds by lenders and many ARM mortgages classify the INDEX as being the LIBOR rate (London Inter Bank Offered Rate). LIBOR closely tracks the Fed funds rate. A typical MARGIN is 2.75 percentage points.
The table below illustrates the newly resetting ARM rate for a case of LIBOR + a MARGIN of 2.75 percent. Note the decline from an 8 percent ARM rate before the Fed's rate cut last year to 5.3 percent today. On a $200,000 interest-only loan, the corresponding monthly mortgage payment falls from over $1,300 to less than $900.
One can also observe from the table below the payment shocks people experienced when defaults began to sharply rise in early 2007. The initial rate on a 2-28 loans and the resetting new loans required monthly payments were close to doubling. (The actual payment shocks could have been slightly less due to legal cap limit on how fast new rate can adjust.) One can further observe that the payment shocks have all but died down recently. This scenario is based on assumptions made in the table. The actual resetting term conditions will vary greatly significantly from loan to loan.
The mortgage payment burden has been greatly reduced for the waves of mortgage that are scheduled to reset in coming months. However, it still does not help the person who faced a reset — say back in November of last year. This person saw a 42 percent jump in payments and the next reset is not likely to happen until November of this year as many reset terms are over the next 12 month period. This person, nonetheless, should seek to modify the loan terms since today's much lower LIBOR rate (thanks to the Fed) can allow for a lower resetting rate — all the while providing the same profit margin for the lenders.
One big current problem is that many mortgage defaults are occurring even before the first date of ARM reset. Some people, particularly the house flippers, are simply walking away — apparently because of falling home values and no perceived profit potential.
In order to stabilize foreclosures, therefore, it is critical to bring homebuyers back to the market place. Tax credit for homebuyers does that.
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