ARMs have legs

It was bound to happen sooner or later. Mortgage rates are going up, and the only questions are how high and whether the pain will be localized or spread across the entire economy.

Freddie Mac reports that 30-year fixed-rate mortgages nationwide hit an average of 6.36 percent for the week ending Nov. 10, the highest average in two years. The rate was 5.76 percent at the same time last year. For one-year adjustable-rate mortgages (ARMs), the average rate was 5.12 percent, compared to 4.16 percent the year before. It was the ninth straight week that mortgage rates rose, and many economists have begun to predict that the end of the housing boom is near.

The problem isn't really the higher rates themselves; it's what people did when the rates were at historic lows over the past few years. Many homeowners acted rationally: They saw the low rates as an opportunity to refinance their fixed-rate mortgages, locking in lower payments. Their actions should benefit them and the economy for years to come.

Others, however, saw the low rates as an opportunity to do what has become a large part of the American dream: Buy things one cannot afford-in this case, expensive houses. ARMs, with their low introductory interest rates, became hugely popular and made up 35 percent of new mortgage loans in 2004-up from 12 percent in 2001-according to Harvard's Joint Center for Housing Studies.

But the trouble with ARMs is that they have legs; their payments climb whenever interest rates rise, as rates are sure to do after hovering at their lowest point in decades. This means that a huge number of homeowners will begin to see higher payments soon. And if rates return to the 8 percent to 9 percent range, as many analysts expect, then a lot of those once-affordable McMansions and "starter castles" could end up on foreclosure lists.

"People are getting in trouble by buying out of their price range," Tina Smith of String Information Services told the Wisconsin State Journal. "They are dreaming really big."

Making the problem worse are the "exotic" features of many ARMs, which also grew in popularity in the last few years. These include "interest-only" loans, in which initial payments are low because they don't pay down principal, and "negative amortization" loans, in which debt actually grows with each payment because the borrower initially pays less than the interest owed each month. Payments on these loans rise dramatically after the first several years, even if interest rates don't go up.

"The dramatic increase in the prevalence of interest-only loans, as well as the introduction of other relatively exotic forms of adjustable-rate mortgages are developments of particular concern," says Federal Reserve chairman Alan Greenspan, who has worried out loud about housing bubbles forming in some parts of the country, especially the West and Northeast (see "Too hot to handle?" June 18, 2005).

Best-case scenario, according to economists: Mortgage rates don't go much higher, housing prices continue to grow but not at the double-digit rate of recent years, and the pain is limited to those who see moderately higher monthly payments on their ARMs.

Worst-case scenario: Mortgage rates return to their historic norms, housing prices in some areas of the country fall, and U.S. economic growth slows and unemployment rises (since housing construction now accounts for 5 percent of the U.S. economy).

"If housing cracks and falls hard," Pimco's Bill Gross told USA Today, "we've got a recession."