Tuesday, April 15, 2008

Interest Rates on ARM Mortgages Are Adjusting… Lower???

Author: Nick
Category: Money
Topics: ,

comic 13 - adjustable rate

In its continuing efforts to convince me to move to Canada, the U.S. economy has decided to further “reward” my decision to avoid risky adjustable-rate mortgages (ARMs) by throwing me this infuriating bit of news: some ARM rates are adjusting down.

Yes, some people are still getting priced out of their homes by their resetting mortgage rates that cause their monthly payments to skyrocket by hundreds or even thousands of dollars, but some lucky fools are now paying less today than they were two or three years ago. How can this be? Well, it all depends on what benchmark a mortgage lender follows when initially setting and later adjusting an ARM’s rate.

For example, consider the case of some bank that, for the sake of protecting the stupid, we’ll simply refer to as XYZ Bank. XYZ Bank has offered numerous adjustable-rate home mortgage loans dating back to 2003. Its most common product is the 5-year ARM—borrowers pay at a fixed interest rate for the first five years, after which the rate adjusts annually but no more than 1% at a time. XYZ Bank also offers 3-year and 1-year ARMs which, as you can surmise from their names, offer fixed rates only for the first three years or one year, respectively. At the time the mortgage loan is issued, and then annually after the fixed-rate period ends, XYZ Bank sets the mortgage’s interest rate based on the 1-year LIBOR rate. (In case you don’t know what the LIBOR is, it’s just an imaginary number established by magical banking elves from the mythical land of England.) The interest rate isn’t exactly the LIBOR rate; XYZ Bank tacks on a few extra percent for profit. The important thing to understand is that XYZ Bank’s ARM rates follow the 1-year LIBOR up or down.

Here comes the fun part. Customer A got a 5-year ARM through XYZ Bank back in March of 2003 when the 1-year LIBOR rate was just 1.34%. Customer B got a 3-year ARM through XYZ Bank in March of 2005 when the 1-year LIBOR rate was 3.84%. As a result, Customer B’s initial fixed rate was likely a couple percent higher than Customer A’s. Fast forward to March of 2008 when both Customer A and B’s fixed-rate periods end and their interest rates adjust by as much as 1% annually based on where the 1-year LIBOR rate is now. In March 2008, the 1-year LIBOR rate was 2.709%. That’s more than one percent higher than Customer A’s initial LIBOR rate and more than one percent lower than Customer B’s initial LIBOR rate.

one year libor index graph

So what happens? To make a long story short, XYZ Bank adjusts Customer A’s rate up by as much as 1% and lowers Customer B’s rate as much as 1%. As a result, Customer A’s monthly mortgage payment skyrockets $500 a month; he can’t afford it, and nobody will buy the house for anywhere near what he paid for it in 2003, so the bank forecloses by the end of Summer 2008. Customer B ends up saving $400 a month and buys Customer A’s house at a foreclosure auction for half of what Customer A paid for it in 2003. Customer A finds out and sleeps with Customer B’s really hot wife for revenge. Customer B and Mrs. Customer B end up getting divorced; she takes Customer A’s original house in the divorce agreement and moves in with her man-mistress (Customer A). Then the LIBOR rate jumps 5% and everyone loses their homes anyway. The end.

And just to prove I’m not making all of this up, here’s a link to a story over at FatWallet.com of a guy whose 3-year ARM just made its first adjustment—down 1% from the initial rate.

As for me, I still have my lovely 6% fixed-forever loan that seems like a really bad idea today but I’ll probably be happy I took in a few years once those ARM rates start shooting up through the stratosphere. Unless, of course, the imaginary English elves have anything to say about it.

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