Preparing for payment shock

Many mortgage borrowers with adjustable-rate mortgages (ARMs) on which the rate has adjusted within recent years are currently enjoying extremely low interest rates. This reflects the unusually low levels of the rate indexes used by most ARMs. But these low rates are accompanied by high anxiety, because of widespread expectations that rates will rise.

For example, the Treasury one-year constant maturity series, which is a widely used index, averaged 0.35 percent in January. This means that the rate on an ARM with a 2.25 percent margin that uses this index and adjusted in January is now 2.6 percent.

Switching to a fixed-rate mortgage (FRM) in today's market, even if the borrower commands the best terms, will about double the rate. ARM borrowers don't want to double their rate before they have to, but neither do they want to be caught flat-footed by a rate increase that materializes before they can make a move.

The stakes are high. The borrower with the 2.6 percent ARM, who was paying 4 percent initially, probably has a maximum rate of about 10 percent and a rate adjustment cap of 2 percent.

That means that if the one-year Treasury rate jumped overnight to 10 percent and stayed there, the ARM rate would adjust to 4.6 percent at the next adjustment, 6.6 percent one year later, 8.6 percent the year after that, and it would top out at 10 percent one year later. Since the FRM rate would escalate with the Treasury rate, the opportunity for a profitable refinance would be lost.

Of course, rates never jump 10 percent overnight -- the process occurs over a period of time, which creates a temptation for ARM borrowers to wait until the rate-increase process starts before making a move. That is easier said than done because the market can move very fast.

In January 1977, for example, the one-year Treasury rate was 5.29 percent. One year later, it hit 7.28 percent; one year after that it was 10.41 percent; and in March 1980 it reached 15.82 percent. That was an unusual episode, but we are now living in unusual times. Indeed, the rise in rates this time could be even faster.

There is no one best way for ARM borrowers to deal with this problem, as it depends on their individual circumstances:

Early movers: ARM borrowers who intend to sell their house within, say, the next 18 months, have little to gain by refinancing, because portable mortgages that can be transferred to the next house are no longer available. Such borrowers have a lot to lose if rates escalate before they buy their next house, but refinancing their current mortgage will not help with that problem. Moving the sale/purchase dates up could be a prudent move. ...CONTINUED

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