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July 24, 2005

ARM's length

I read a very interesting point in the Wall Street Journal the other day that I thought I'd pass along to my readers. Like many other people I know, I have noticably seen the amount of money I spend on my car increase because of the upward spike in gas prices. I drive a pretty fuel efficient car (Honda Accord) but before I started riding MARTA to work, I was seeing my weekly fuel costs top $30 (two years ago they would have been closer to $15) which added up to $60 a month more. I would imagine that people that A) drive less fuel efficient cars than I do and B) have longer daily commutes have seen their additional costs approach nearly $200/month.

If you think fuel increases have caused a budget crunch, just wait until adjustable rate mortgages start adjusting upward. The WSJ (as well as Kevin Drum and others) have noted that more than $1 trillion of mortgage debt readjusts in the year 2007, at which point someone who got a mortgage in 2002 could see a rate of 4.5% readjust to 6.5%. On a $225,000 house that's $282 more a month. What's more, many people signed agreements (in exchange for even lower temporary rates) that prevented them from paying off the loan early (like by a refinancing) without paying thousands of dollars, generally around $25,000. So if you're up to your neck in debt, you can always trade in that gas guzzling SUV for a fuel efficient Honda Civic, but you can't refinance OR even sell your home without facing a hefty penalty. Someone that sells or refinances could face a hefty loss of equity -- in effect the real estate bubble will burst for millions of Americans (they'll lose value) even if no bubble bursts.

So what can you do? If you find yourself in an extreme scenario, start considering your options. How much of your loan can be paid off without triggering a pre-payment penalty? It probably makes sense to refinance at least that amount. And if you are purchasing a new home or refinancing, secure as much of your debt as possible in a fixed rate investment.

As an example, for less than $1,400/month, you can borrow about $225,000 towards the purchase of a property with a fixed interest rate. If $1,400 was the limit for your budget, it doesn't make much sense to seek out a creative source of financing that allows you to purchase a more expensive home but has no guarantee of a future affordable payment. Payments will almost certainly be $150 more a year from now and could easily be upwards of $300 more per month.

I hate to sound like a scold, or Clark Howard, but here's one more final example that unfortunately may be all too real for a lot of Georgians. A number of homeowners took out interest only adjustable rate mortgages (ARMs). These mortgages feature a low introductory rate (say 3.5%) for a period of 5 years, during which time the borrower only has to pay the interest that is accruing on the loan. Again, on a $225K loan, that's about $656/month. At the end of 5 years, however, the rate starts readjusting (usually on an annual basis) AND the borrower has to start amortizing the loan (paying down the principal borrowed). Right now, that rate would adjust to about 5%. But the Fed has indicated that it plans on continuing raising rates, so a year from now (when many of these loans start readjusting) the rate will be at least 6% and maybe higher. The combination of a 6% rate and having to amortize the loan raises the monthly payment to $1449/month, an increase of $793/month or 121%! That makes $2 gas seem like a very minor inconvenience, unless you drive a Hummer 100 miles a day to work and back.

Helpful Tip: If you've got an adjustable rate mortgage, you can see what you're in store for pretty easily with Microsoft Excel. Here's an example formula to enter in to a cell. In my example, the interest rate is 6%, the number of months left in the loan is 300 (25 years) and the balance of the loan is $225,000. Simply type =PMT(.06/12,300,225000), press enter and $1,449.68 should appear in the column. That's the monthly payment on a mortgage with those variables.

Posted by Chris at July 24, 2005 02:40 AM

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Posted by: Pappy at July 24, 2005 11:07 PM

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