Adjustable rate mortgages bite borrowers

By LESLIE BERKMAN
Tuesday, November 21, 2006
While listening to the radio in the summer of 2005, Mike Spanos heard a commercial for a mortgage promising a 1 percent interest rate for three years.

"I thought it was a great deal," said Spanos, who had lost his job and was looking for a way to cash out money from his home to live on.

So Spanos refinanced his house in Montclair, Calif., he said, without understanding that the 1 percent interest rate that attracted him was the smallest of several payment sizes he could choose. It did not cover the actual interest charged on the adjustable-rate mortgage, which changed monthly, recently reaching almost 9 percent.

Two months ago Spanos, 42, was shocked to learn that by making monthly payments of $3,034, including property taxes and mortgage insurance, he had allowed the debt on his house to grow by $9,000.

Throughout the nation, homeowners who have benefited from creative financing _ pushed by the lending industry to make housing initially more affordable _ are awakening to its downside.

In recent years, home buyers have increasingly chosen alternatives to traditional 30-year fixed-rate mortgages to buy a first home or a nicer one than they otherwise could afford in a real-estate market where prices were skyrocketing.

Such mortgages are designed to give borrowers an interest rate that starts lower than for a 30-year fixed-rate mortgage and then rises or falls along with the market rate. By sacrificing the certainty of a fixed interest rate for the life of a mortgage, the borrower gains temporarily lower house payments.

But the recalibrating of ARMs when interest rates are rising can be life-changing for those who aren't prepared.

"The problem is in the past few years, short-term interest rates have moved up substantially, so the initial rate reset will be a doozy for some people," said Greg McBride, senior financial analyst with Bankrate.com, a personal-finance Web site.

If a homeowner three years ago borrowed $400,000 at an adjustable rate of 4.25 percent that reset at the current 7.5 percent adjustable rate, McBride said, the monthly mortgage payment would jump from $1,967 to $2,730.

RealtyTrac Marketing Vice President Rick Sharga said mortgage lenders in recent years relaxed their standards to allow people with lower credit scores to become homeowners with "subprime" adjustable mortgages.

"Underwriting standards have gone down because everyone was trying to get their share of the market," he said. "You can't absolve the home buyer from all guilt either. If this is the biggest investment you will ever make, shouldn't you understand what you are signing?"

While homeowners with traditional adjustable-rate mortgages are starting to feel pinched, an even sharper jolt awaits homeowners who chose some even riskier varieties.

Some mortgages allow payments for a specific number of years that only cover the interest owed. But then the borrower faces far higher monthly payments because he has to retire the entire principal over the remaining life of the mortgage.

An interest-only loan also can have the future uncertainty of an adjustable interest rate. McBride said someone who took out an adjustable-rate, interest-only mortgage for $400,000 three years ago that recasts now to include the principal will see his monthly mortgage payment more than double from $1,416 to $2,883.

Option ARMs take a variety of forms but generally allow a buyer three choices each month: pay the full payment including interest and principal, pay interest only or pay a minimum payment that's even less. When buyers choose the minimum payment, the unpaid interest is added to the loan balance. Spanos opted for the minimum payment.

The financial future of option-ARM borrowers, like Spanos, depends on their choices.

Spanos said until recently he had no idea how his option ARM worked or that the payment he was making was piling more debt on his house. He said he wants to refinance into another loan but is having difficulty because of the equity he lost and because he must pay a penalty if he refinances before three years.

The bachelor, who has landed a new job with an annual salary of about $68,000, said he doesn't want to sell the four-bedroom house he calls his "dream home." But he said even with a roommate, he can't afford to boost his monthly payment from $3,034 to $4,985 to cover the interest or to $5,334 to start paying interest and principal.

After getting the latest rejection from a lender for refinancing, Spanos said, "It doesn't look good. It looks like I am stuck in this loan."