> Advice For Borrowers
High-End Markets, Low-Income Households, Minorities May Have Too Many ARMs
by Broderick Perkins
Adjustable rate mortgages can help overcome the high cost of housing, but disproportionate use of the loans in some regions and by some demographic groups is causing alarm among financial experts and consumer advocates. Only 18 percent of consumers nationwide opted for adjustable rate mortgages (ARMs) in 2003, according to data from the Federal Housing Finance Board released by the Homeownership Alliance. But in Colorado and Michigan, 30 percent of home purchase loans for adjustable rate mortgages, the highest in the nation. Those states were followed by California (29 percent); Illinois (27 percent) and Washington, D.C. (25 percent). Smaller, more local markets reveal strikingly higher levels of ARM use. In California's Silicon Valley, for example, the use of ARMs was as high as 68 percent in November 2003, according to DataQuick. Ironically, the same high cost that drives home buyers to ARMs compounds the risk associated with them. Lower-income households, which can least afford the risks associated with ARMs, are also more apt to use an ARM to buy a home. Lower-income households, along with ethnic minorities, who reveal less knowledge about the risk of ARMs, are more apt to use them than others. "The good news is that about two-thirds of Americans not only prefer fixed rate mortgages but appear well-aware of the risks of ARMs," said Stephen Brobeck, executive director of the Consumer Federation of America (CFA) a Washington, D.C.-based non-profit consumer advocacy agency. "The bad news is that lower-income and minority Americans are not only those most likely to prefer ARMs, but also those with the poorest understanding of their risks," he added, referring to a recent CFA study. The study, "Lower-Income and Minority Consumers Most Likely To Prefer And Underestimate Risks Of Adjustable Rate Mortgages," couldn't be more timely. Interest rates have been trending up for the first time in years. When rates rise, so does the cost of ARMs. The CFA study found that 37 percent of Hispanics and 31 percent of African-Americans preferred ARMs, compared to 23 percent of whites. It also found that 33 percent of those with incomes under $25,000 preferred ARMs, compared with 20 percent of those with incomes over $50,000, prefer ARMs. In the study, all respondents were asked to estimate the annual increase in mortgage payments if the 6 percent interest rate on a $200,000, 30-year ARM -- with annual payments of $14,400 -- rose by two percentage points to 8 percent. A far higher percentage of Hispanics and African-Americans (43 percent) and those with incomes under $25,000 (44 percent), than of all Americans (35 percent), could not estimate the increase. It's not surprising that fixed-rate mortgages have been the cornerstone of the U.S. housing finance system. They come with, well, fixed interest rates. The monthly mortgage payment remains the same month after month, year after year for the term of the loan. A fixed amount is easier to budget for over the long term. ARMs, on the other hand, are cheaper -- at first. There are myriad ARMs and how much cheaper they are initially and how long they remain cheaper, varies immensely, based upon how long the initial rate lasts (from about six months to 10 years) and based upon the size and frequency of subsequent adjustments written into the loan contract. The cheaper initial rate can allow a home buyer to qualify for a mortgage that may have been out of reach with a higher FRM rate. A lower interest rate, means a lower monthly mortgage payment. Landing a lower monthly mortgage payment is the big reason home buyers in expensive markets choose ARMs over FRMs. What's more, ARMs can indeed adjust down and get even cheaper, as many have in recent years. In addition to the lower initial rate and the ability to become even cheaper, ARMs come with a little known advantage attached to the lower rate. When mortgage loan interest is cheaper, a smaller portion of the monthly mortgage payment goes toward the interest and a larger portion of the monthly mortgage payment goes to the principal. Theoretically, that can allow the borrower to gain equity faster than with a more expensive loan, because, as the loan's principal balance shrinks, equity grows. That's true, however, only as long as the interest rate remains relatively lower. "My most recent mortgage was fixed for the first year and is now down from 5.75 percent to 3.804," said Mark R. Hart, a wholesale account executive with ACT Mortgage Capital in Sunrise, FL. "(Federal Reserve chairman) Alan Greenspan recently said the public is not being well served by taking fixed mortgages. High interest rates never stay high as long as people think. I can't recommend them for everyone, but the only person who should take a fixed rate is if they barely qualify and are unlikely to have increases in their pay," Hart said. What Greenspan really said in a speech during Credit Union National Association 2004 Governmental Affairs Conference, Washington, D.C. on February 23 this year was, "Indeed, recent research within the Federal Reserve suggests that many homeowners might have saved tens of thousands of dollars had they held adjustable-rate mortgages rather than fixed-rate mortgages during the past decade, though this would not have been the case, of course, had interest rates trended sharply upward. American homeowners clearly like the certainty of fixed mortgage payments...American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage. To the degree that households are driven by fears of payment shocks, but are willing to manage their own interest rate risks, the traditional fixed-rate mortgage may be an expensive method of financing a home." He also later told the media he had not intended to "disparage" the fixed-rate loan, which he called one of the "great inventions" of our time. He said he spoke "imprecisely" and should have explained that his comments were focused on a narrow segment of consumers who are not well served by fixed-rate loans. Sean Sullivan, vice president of Princeton Capital in Los Gatos, CA agrees. "We don't really focus on that as much as the danger of the payment in three, five, seven or ten years when the ARM is done. We try to focus on cash flow and what will happen to your income over a certain period of time and the traditional arguments you make for and against an arm," said Sullivan. Lately, interest rates have been on the rise and, chances are, even more buyers are using them in Silicon Valley and high cost regions, because home prices also have been rising. When 68.1 percent of Silicon Valley's home buyers were using ARMs, for example, the median price for all homes (single-family detached, condos and townhomes) in Silicon Valley was $487,000. In May, the Silicon Valley median was up almost 13 percent to $549,000, according to DataQuick. Once interest rates begin to ratchet up, so does the monthly cost of ARMs. The larger the balance, as in high-cost regions like Silicon Valley, the greater the financial impact. If the homeowner can't afford the new amount or can't refinance to a fixed rate or other ARM with a manageable monthly payment, the household could lose the home. "Hindsight is 20-20," says Sullivan. | 
