NEWS: The Trillion-Dollar Bet

June 16, 2005

The Trillion-Dollar Bet

By DAVID LEONHARDT and MOTOKO RICH

American homeowners have made a trillion-dollar bet that mortgage rates will remain near record lows for at least a few more years. But with some interest rates already rising, economists worry that the bet could turn bad.

The problem is that new types of mortgages that hold down monthly payments for families - helping many buy homes that they would not otherwise be able to afford - also require potentially far higher payments in future years.

The bill will soon start to come due in a serious way, as the initial period of fixed payments, typically set at artificially low rates, expires for millions of homeowners with adjustable-rate mortgages.

This year, only about $80 billion, or 1 percent, of mortgage debt will switch to an adjustable rate based largely on prevailing interest rates, according to an analysis by Deutsche Bank in New York. Next year, some $300 billion of mortgage debt will be similarly adjusted.

But in 2007, the portion will soar, with $1 trillion of the nation's mortgage debt - or about 12 percent of it - switching to adjustable payments, according to the analysis.

The 2007 adjustments will almost certainly be the largest such turnover that has ever occurred.

The impact is not likely to derail the economy on its own, economists predict, but it will probably slow growth. For individual families, the problems could be significant.

"I'm not sure that people are being counseled on really how big of a risk they are taking," said Amy Crews Cutts, deputy chief economist at Freddie Mac, the mortgage company.

Consider a typical $300,000 interest-only mortgage with fixed payments for the first five years.

The homeowner would start by paying about $1,250 a month. If interest rates rise modestly over the next few years, as many forecasters expect, the payment will jump to almost $2,100 in 2010, according to Stephen Barrett, the owner of Redmond Financial, a mortgage business near Seattle.

With the help of new computer models, lenders have brought out newer and riskier mortgages to attract borrowers and increase their buying power during the long housing boom. The traditional 30-year mortgage with guaranteed payments is increasingly a loan of the past.

The hot loan of 2004 - the interest-only mortgage - allowed home buyers to pay no principal for the first few years of the loan, substantially lowering their initial payments.

It has remained popular this year, accounting for at least 40 percent of purchase loans over $360,000 in areas with fast-rising home prices, like San Diego, Washington, Seattle, Reno, Atlanta and much of Northern California, according to LoanPerformance, a mortgage data firm.

This year's fashionable model, known as an "option ARM," allows borrowers to make payments with monthly rates starting as low as 1.25 percent for the first five years of the loan; the average rate on a 30-year, fixed-rate loan is about 5.6 percent.

During the first quarter of 2005, 40 percent of mortgages over $360,000 issued to people with good credit were option ARM's, said David Liu, a mortgage strategy analyst with UBS in New York. Very few borrowers used option ARM's before 2003.

Many borrowers stand to benefit from these creative loans. On option ARM's, buyers with variable incomes, like the self-employed, can also make smaller or larger payments depending on their take-home pay in a particular month, without incurring penalties. With the average homeowner moving every six years, any loan with lower initial payments can substantially reduce housing costs.

"As a rule, I would prefer the 30-year fixed mortgage," said Alejandro Brown, 31, a technical trainer for Nissan, the automaker, who refinanced the mortgage on his 1,700-square-foot house in Auburn, Wash., with an adjustable-rate loan last year, reducing his monthly payments. But, he said, "I knew I wasn't going to be in my house more than three years; I was very confident."

All of these loans come with the risk of a spike in payments sometime in the future. In particular, borrowers who have taken out an interest-only loan will see a jump in payments simply because they will start to owe principal after the interest-only period lapses. If rates rise, the payments will go even higher.

Borrowers whose incomes have not risen enough or who have not planned for the higher payments could find themselves shocked.

"The apparent froth in housing markets may have spilled over into mortgage markets," Alan Greenspan, the Federal Reserve chairman, said while testifying to Congress last week. "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."

The lure of such loans is obvious. Because of the lower initial payments, buyers can purchase bigger and more expensive houses.

With her daughter leaving for college this summer, Linda Thompson decided to sell her four-bedroom house in the Seattle suburbs and move to a town house in the city's Lake Union neighborhood. But prices were so high that she had to go beyond her "level of comfort," she said, and spend $619,000.

She signed an interest-only mortgage that cut her monthly payments by about $500 compared with a conventional mortgage. Seven years from now, the bill will rise as she starts paying principal, and the size of the increase will be determined by interest rates at the time. But she may have moved by then, she said. And because the house is in an up-and-coming neighborhood, she expects the value to rise.

"The risk factor - of course it's always there," Ms. Thompson, 49, who runs a small marketing company, said as she was preparing to watch her daughter graduate from high school yesterday. "But to me, real estate is a better investment than the stock market."

"Just sitting there," she said of her new house, "it's appreciating right now."

Still, even some mortgage brokers are concerned by how much their clients are stretching their spending power using creative mortgages.

One possible warning sign is that a growing share of those taking out the aggressive loans is made up of lower-income families living in expensive areas, according to Economy.com, a research company. Another is that variable-rate mortgages have stayed popular even as long-term, fixed rates have gone down and rates on adjustable mortgages have risen.

"There are people who are buying homes that they shouldn't buy," said Eric Appelbaum, president of the Apple Mortgage Corporation in Manhattan. "People are saying, I can afford it on interest-only but I can't afford it" with a traditional mortgage, Mr. Appelbaum said. "It doesn't make any sense."

Since borrowers with interest-only mortgages are not yet paying down their debt, they are hoping to build up equity through an increase in home values. If house prices fall, as they did during the early 90's in some cities, borrowers will be forced to bring money to the table when they sell.

Even if home prices rise a little, borrowers who have taken out option ARM's and made only minimum payments for five years could find themselves in a hole. Such loans, which are typically based on rates that adjust monthly, give homeowners four payment options each month. In the first quarter of 2005, 70 percent of option ARM borrowers made the minimum payment, according to UBS.

In doing so, those borrowers effectively added more debt to the back of their loans.

On a $400,000 loan, for example, a buyer who made only minimum payments over the first five years would add more than $27,000 to the end of the loan, assuming short-term rates increase by one percentage point over the course of the loan, said Robert Binette, a mortgage broker with Hamilton Mortgage in Ridgefield, Conn. The monthly payment would jump from $1,718 in the final month of the fifth year to $2,580 after the loan was reset, a difference of more than 50 percent.

Borrowers who expect to cover the larger debt by refinancing could be in trouble if rates have increased. Thirty-year fixed-mortgage rates are near their lowest level in a generation.

Nationwide, the increase in monthly payments as more mortgage rates start to float will cost families about an extra $40 billion over the next two years, according to estimates by Credit Suisse First Boston. That is the rough equivalent of a 40-cent increase in gas prices over the same span, which would pinch incomes but would not be likely to create a recession.

The biggest concern, many economists say, is that the new mortgages have come onto the market at a time when low interest rates and rapidly rising home prices are the only reality many people can imagine. Families might be making decisions assuming that combination will last forever.

In a speech to bankers in New York, Donald L. Kohn, a Federal Reserve governor, said yesterday that he expected a strong economy over the next few years.

"My message this morning, however, is that this is not a time for complacency," he said.

There is "significant uncertainty," he added, because some recent financial innovations "have not yet been rigorously stress-tested."