As Short-Term Interest Rates Rise
By Ruth Simon
From The Wall Street Journal Online
The cheap mortgage that helped pump up the housing boom is finally in retreat.
Demand for so-called option adjustable-rate mortgages has dropped 25% in recent months, according to estimates by UBS AG. Just this summer, these loans accounted for more than 30% of jumbo mortgages, UBS says. Option ARMs carry teaser rates of as low as 1% and give borrowers multiple payment choices, but can lead to a rising loan balance.
At Washington Mutual Inc., option ARMs accounted for 29% of mortgage volume in the third quarter, down from as much as 40% a year earlier. IndyMac Bancorp says option ARMs fell to 31% of its loan volume in the third quarter from 39% the previous quarter.
The declining popularity of option ARMs comes as short-term interest rates have risen and some lenders have raised prices on these loans for new borrowers. As a result, fixed-rate mortgages are regaining popularity and some borrowers are becoming disenchanted with their option ARMs. Regulators have raised concerns about the risks of these complex loans and whether borrowers truly understand them. At least one lawsuit has been filed against a lender alleging that it misled consumers when it sold them option ARMs and more lawsuits could be coming.
The recent decline in option-ARM demand could mark the end of an era in which new mortgage products have made it easier for borrowers to afford ever-more expensive homes. Option ARMs have been especially popular in high-cost markets, such as California. They also allowed many homeowners to refinance existing mortgages in order to tap the equity in their homes while keeping their monthly payments low. By helping borrowers stretch, these loans helped boost demand for housing in the hottest markets. "The fact the loans are no longer available on such attractive terms ... could mean that the boom is ending in some of those markets," says Arthur Frank, director of mortgage research at Nomura Securities International in New York. Existing-home sales fell 2.7% in October from September as inventories of unsold homes continued to creep higher.
An option ARM is an adjustable-rate mortgage that carries an introductory rate of as low as 1% and gives borrowers multiple payment choices. These choices typically include a minimum payment, which is set at the start of each year, an interest-only payment and the standard payment on a 15-year or 30-year mortgage.
Many borrowers have been attracted to option ARMs by the low introductory rate, which is used to set the minimum payment for the first year. But that teaser rate is in effect for only a short period, typically one to three months. After that, the rate on the loan can jump above 5% or 6% and continue to rise as short-term interest rates move higher. Option ARMs are considered particularly risky because borrowers who elect to make the minimum payment can see their loan balance grow, also known as negative amortization.
Some borrowers say they weren't clearly informed of these features. Susan Andrews, a registered nurse, and her husband, Bryan, a carpenter, refinanced their $191,000 mortgage into an option ARM last year after receiving a promotional mailing offering a mortgage with a 1.95% rate. "We have four children, three who are college age," Ms. Andrews says. "We thought this would decrease our monthly debt."
Ms. Andrews says she thought the 1.95% rate on the loan was fixed for five years. But two months after obtaining the mortgage, the couple received a statement showing that their interest rate had jumped to 4.375%. Since then, the rate has climbed above 7% and the couple's loan balance has grown by about $2,000, even though they've made extra payments toward the principal.
In a lawsuit seeking class-action status filed in U.S. District Court in Milwaukee earlier this year, the Andrews allege that their lender, Chevy Chase Bank, violated the federal Truth-In-Lending Act by misleading borrowers into thinking they were getting rates lower than those actually charged. There are "deceptive disclosures," says Kevin Demet, an attorney representing the Andrews.
In a written response to questions about the lawsuit, Robert D. Broeksmit, president and chief executive of Chevy Chase Bank's mortgage lending unit, says the company offers option ARMs "only to affluent borrowers who use its various payment features to manage their cash flow intelligently." He says the bank makes "every effort to ensure that all of our customers understand the loan product they choose." This includes providing a "one page, large print, plain English flyer, which the borrower signs, which clearly states that the loan has a monthly adjustable interest rate," he says.
Other lawsuits are likely, particularly if interest rates rise and housing values level off or fall, says Paul F. Hancock, a partner with the Miami office of law firm Hogan & Hartson. "The most likely claim will be a consumer-protection claim ... [that borrowers] weren't properly informed or were sold a product that wasn't suited to them," he says. Mr. Hancock says the risks of option ARMs and other exotic loan products are getting more attention both from lenders and consumer advocates.
The growth of option ARMs has caught regulators' attention. Last year, the Federal Trade Commission obtained a preliminary injunction barring a Nevada mortgage broker from misrepresenting the terms of the option ARMs it sold. Comptroller of the Currency John C. Dugan said in a speech last month that option ARMs "expose borrowers to substantially increased levels of payment shock."
Here's why: Lenders typically limit how much the minimum payment on an option ARM can grow in most years. But that limit is typically lifted once every five years so that the borrower is put back on track to pay off the loan over the original 30-year period. The limit also is lifted if negative amortization pushes the loan balance above a preset level.
Even if interest rates remain stable, a borrower who made the minimum payment could see their payment jump more than 50% at the start of year six, according to Mr. Dugan. And if rates rose two percentage points during the loan's first five years, the monthly payment could nearly double.
Electing to make the minimum payment also could cause a loan's balance to swell. For example, a borrower who took out a $400,000 option ARM in January and made the minimum payment each month could wind up owing roughly $410,000 by the end of the first year, according to Dominion Bond Rating Service. Roughly 70% of borrowers with option ARMS are currently making the minimum payment, UBS says.
To be sure, option ARMs have been around for years and are likely to remain attractive to some borrowers. They could regain some of their popularity if the gap between short-term and long-term interest rates widens, making these loans more attractive. In addition, not every lender is seeing a dip. GreenPoint Mortgage, a unit of North Fork Bankcorp, says option ARMs accounted for 34% of its loan volume in the third quarter, up from 29% in the previous quarter.
Lenders' recent price increases on option ARMs have helped make these loans less attractive to new borrowers. Some lenders have boosted the introductory rates, which are used to set the minimum payment. Other changes raise the so-called margin that helps determine the rate on the loan once the teaser period ends.
This fall, for instance, Washington Mutual boosted the margin on its option ARMs to 2.65 percentage points from 2.30 percentage points. In October, it raised the margin further to 2.70 percentage points and boosted the introductory rate on these loans to 1.375% from 1.25%. The changes make the loans more profitable, Washington Mutual President Steve Rotella said in a conference call with analysts, but "may result in lower volumes."
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