Interest rates are rising, and adjustable-rate mortgages are growing in popularity because they allow borrowers to start out with lower monthly payments.
And borrowers most likely to prefer ARMs – low-income and minority homebuyers – have the least understanding of the potential cost, according to a new study.
“Given the high probability of interest rate increases, an adjustable-rate loan made to a family which can barely afford the initial monthly payments represents a ticking time bomb,” said Stephen Brobeck, executive director of the Consumer Federation of America, which funded the study.
Unlike a fixed rate, in which a borrower locks in costs for the length of a loan, the rate on an ARM fluctuates with market conditions. If rates go down, the borrower benefits.
Federal Reserve Chairman Alan Greenspan said this year that in the past decade, when rates hovered at historic lows, consumers could have saved thousands of dollars each if they had ARMs instead of fixed-rate loans.
But with rates rising, that could change, adding hundreds or even thousands of dollars to a borrower’s annual interest expense.
The average rate on a 30-year fixed loan was 5.6 percent in the first three months of 2004, and the rate has been hovering around 6 percent in recent weeks.
The Mortgage Bankers Association expects it to inch up to 7.1 percent next year and 7.9 percent in 2007.
According to the Mortgage Bankers Association, a Washington, trade group, ARMs accounted for only 19 percent of loan originations last year but are expected to account for 34 percent this year and 38 percent next year.
Hybrid ARMs – which have a fixed rate for maybe three, five, or seven years before the adjustable rate kicks in – particularly have been growing in popularity.
The survey found that two-thirds of those surveyed preferred fixed-rate loans and were aware of risks posed by ARMs.
Those who were most likely to prefer ARMs were the younger, poorer, and less educated respondents, however.
Hispanic and African-American respondents also were more likely to prefer adjustable-rate loans.
Opinion Research Council International polled 1,015 people – 64 percent of whom were homeowners and 26 percent renters – from July 8-11.
When asked to estimate the increase in mortgage payments on a $200,000 loan that started at 6 percent and rose to 8 percent, the respondents underestimated the amount by approximately 30 percent.
The correct answer is $3,210 over a year, but the average estimate by respondents was $2,248.
Hispanics, young adults, poor people, and those with no high school degrees underestimated the true cost by 40 percent to 50 percent.
“The traditional role of ARMs is to be a tool for the wealthy, educated, and most aware consumers to try to take advantage of market fluctuations,” said Brad Scriber, the federation’s housing coordinator.
“We were surprised to find that low-income and minority borrowers prefer variable-rate mortgages. Predicting rates is as difficult as predicting the stock market.”
Experts say that even in a rising rate environment, ARMs still have a role.
For instance, a borrower who expects her income to increase substantially in future years might benefit. Or if a couple plans on selling a house in five years, a hybrid might make sense; they can sell the house before the rates go up.
Although the survey questions pertained only to home purchase loans, adjustable-rate home equity loans bring the same risks, Scriber said.
Consumers should also be especially wary of the delayed financial impact of interest-only loans, which many banks have been pushing, Scriber said.
For millions of Americans, home ownership acts as a forced savings plan as the principal paid is like money in the bank, he said.
But with interest-only loans, a borrower builds up no equity.
“An interest-only mortgage doesn’t contribute to wealth in the same way,” he said.
The study, released Monday, “reinforces what we know to be the case,” said Ken Zimmerman, executive director of the New Jersey Institute for Social Justice, a Newark-based research and advocacy group that studied home foreclosure patterns in low-income neighborhoods and supported an anti-predatory lending law in New Jersey.
“The complexity of the mortgage process brings potential for abuse.”
Heather McElrath, spokeswoman for the American Bankers Association, said the federation “raises some valid points about consumer education,” but “we have no evidence there have been aggressive tactics to promote ARMs to those who cannot afford them.”
Doug Duncan, chief economist of the Mortgage Bankers Association, was more critical of the survey.
“They set out with a point of view that it was looking to have supported,” he said.
Duncan said an executive summary of the study “inferred that lenders can be better off if a customer takes out a loan and goes into foreclosure.” The opposite is true, Duncan said.
The question that stumped respondents about the impact of higher interest rates was “not a realistic survey question,” he said.
“Even I couldn’t answer that question without my HP financial calculator.”
Source Citation (MLA 8th Edition) Newman, Richard. “Study sees rising risk in ARMs; Borrowers may fail to weigh pitfalls.” Record [Bergen County, NJ], 28 July 2004, p. B01. Infotrac Newsstand, http://link.galegroup.com/apps/doc/A119857751/STND?u=fairfax_main&sid=STND&xid=074fafbd. Accessed 24 Mar. 2019.