A.R.M. WRESTLING

Until five years ago, a home mortgage was a fairly simple loan. You borrowed the principal you needed at a given interest rate (remember when 8 or 9 percent seemed high?) and paid a fixed amount each month for 20, 25 or 30 years. Now, however, with banking deregulation and higher, wildly fluctuating interest rates, the mortgage-lending business has complicated itself nearly beyond recognition. Good old-fashioned mortgages, now tagged “conventional” or “fixed rate,” are rapidly being relegated to the financial graveyard. The newfangled replacements, adjustable rate mortgages (ARMs), offer loans to home buyers for a possibly changeable principal amount at a changing interest rate and changeable monthly payments. (Got that nailed down?) According to Tom Anderson, vice president of residential administration for the financial corporation of Lomas & Nettleton, more than 50 percent of new mortgages made in the D/FW area are some form of ARMs. An adjustable rate mortgage typically carries a low first-year interest rate that can fluctuate at set intervals, depending on a given interest rate index. Some ARMs also have a negative amortization feature, which allows the difference between the lower monthly payment and the high rate of interest due to be tacked on to the principal balance. This means that while the monthly payments may seem nice and low, the loan is actually increasing with each payment made!

Because more buyers can qualify for loans to purchase homes from overstocked builders with lower first-year interest rates, ARMs have been touted for several years as the best thing for the housing industry since sliding doors. But today, many homeowners are up in ARMs over prohibitively large increases in their monthly payments, negative equity that is created as a result of increased principal due, subsequent losses and home defaults.

Discovering that you owe thousands of dollars more than you originally borrowed to buy a house is known in the trade as “collateral shock.” It’s the flip side of “payment shock”: the huge monthly payment increases experienced during times of high interest rates.



LET’S LOOK AT a typically deceptive loan: John and Jane Doe take out a $100,000 ARM that advertises monthly payments based on 5 7/8 percent interest in the first year (about $450 per month). Sounds great, right? Keep your eyes open. The real interest rate is 13.75 percent or the equivalent of about $1,150 per month. Each month, the $700 difference is added to the $100,000 balance. At the end of the first year, they owe $8,000 more than they originally borrowed! The next year, their loan escalates to 2 or 3 percent more than some fixed index-to about the 13.75 percent level-and their monthly payments jump to the $1,150 level. Payments can increase each year without a letup, and they must make them or lose their house. The ratio of defaults on excessively volatile ARMs such as these has led many companies to curb excesses and to develop some guidelines to help consumers steer clear of disaster.

The most conservative loans have no negative amortization built into them. The monthly payment, although higher, covers the required interest and principal payment. These loans also feature limits-or “caps,” as they’re called-to the number of years any change can be made, the amount the interest rate can increase each year and the maximum interest that can be charged. A five-year first-year 10 percent interest ARM with a 2 percent annual cap and a 15 percent lifetime cap means that a 10 percent interest rate first-year monthly payment of $877 per month on $100,000 can go up only to $1,028 (12 percent) the next year, to $1,184 (14 percent) the third year, to no more than $1,264 (15 percent) ever, and will remain fixed after five years at the final rate.

The obvious reason for this trend away from fixed rate mortgages to ARMS, according to Dan Stoltje, senior vice president of Lomas & Nettleton, is a combination of incentives. First, with an ARM, there is less question of qualifying for the loan. Also, there’s the security of knowing the absolute cap that the rate can climb to in future years (specified in the agreement). Finally and primarily, ARMS come on stream at a lesser rate than the fixed interest rate. Stoltje says that the attitude with younger people to go for an ARM seems to be “I’ll take this because I can get it,” and that in this upwardly mobile community, they tend to be earning more the next year to compensate for any rate hikes. However, Stoltje emphasizes the point that rates can also go down.



ONLY IF YOU believe you can pay the additional $150 per month next year should you consider a loan of 30 years. If you’re on a fixed income or you simply aren’t getting big raises or bonuses each year, don’t be tempted by payments that are affordable for only one year.

However, as Anderson points out, if you can risk payment volatility, you may not need the security of caps. Starting interest rates will be lower without caps, since the lender is not risking a below-market rate of return.

Several pressures created ARMs. Savings & loan associations (S&Ls) use savings deposits to cover mortgage loans. These deposits are short-term and, with deregulation, there is no longer a limit on what might need to be paid to depositors. S&Ls were borrowing short and lending long and, during high-inflation times, got caught paying depositors more than they were getting on many old loans. No one wants to get caught with a 30-year 10 percent note if the prime is going to hit the 20 percent range again. Private mortgage companies, which rely on institutional sources of funds, also find no financial backers for long-term fixed-rate loans. Now, with adjustable rate mortgages, borrowers will be sharing some of that risk.

Conservative lenders, however, never offer negative amortization as a feature of any loan. In numerous instances across the country, hefty losses stemmed from large amortization balances due at the time of the sale of a house that had not appreciated enough to cover the increase. To guard against these losses, home buyers should stay away from negative amortization and low “teaser rates.”



THE FOLLOWING CHECKLIST should help start your mortgage investigation:



1. Have caps-interest rate ceilings-forboth monthly payments and the amount ofchange over the life of the loan. Be sure toknow what next year’s worst-case increasecould be.

2. Know what negative amortizationmeans and what you’ll be getting into if youchoose it as a loan feature.

3. Know the index that will be used to adjust the rates. Look for known and widely published ones such as the Treasury or Federal Reserve indexes.

Also know the “margin,” or percent increase over this index, that your payments will be adjusted to.

4. Have no prepayment penalty and a convertible feature so that you can switch to a lower fixed-rate loan or a more favorable ARM when and if rates go down in the future.



YOU CAN SHOP around for mortgages from S&Ls, banks and mortgage companies. Be sure you’re getting the best rates available and that the full implications of your loan-from best case to worst case-are explained to you. If there is no limit to the worst case, or if you don’t get the explanation you need, move on.