Faced with difficult adjustments, homeowners weigh their options

Many homeowners who scrambled into the arms of an adjustable-rate mortgage over the past few years are now reconsidering their relationship. Adjustable-rate mortgages (ARMs) entice buyers with lower introductory interest rates – sometimes fixed for a limited period of months or years, sometimes not. That rate changes at a designated time based on any one of several indexes.

Simply put, an ARM is attractive to borrowers with spotty credit records as well as those trying to buy a house that's more expensive than they could typically afford. ARMs can also be a good fit for buyers who plan to live in a house for a limited time.

Whatever the scenario, the adjustable portion of these loans has proved difficult this year as interest rates increased. ARMs account for 25 percent of home loans across the country and the struggles of homeowners are only likely to grow through 2007 as more ARMs reach the adjustment period, analysts predict.

"People who take ARMs are more risk-tolerant," says Doug Duncan, chief economist at the Mortgage Bankers Association in Washington, D.C.

Earlier this month, the MBA reported delinquency rates on home loans for the second quarter of this year. As expected, the percentage of homeowners with ARMs unable to make payments on time increased in comparison with the first quarter of 2006 as well as the same period last year.

In addition, the rate and number of adjustable-loan delinquencies continued to outpace fixed-rate loans by a wide margin.

Experts offer several suggestions for ARM-holders feeling the pinch of loans resetting at new, higher rates. Among the options: refinancing to a fixed-rate loan, negotiating better terms with your current lender, or selling the house and downsizing to a more manageable mortgage, or even renting property for the short term.

In each case, the key – as in every aspect of financial matters – is preparation. Financial planners and other experts begin each answer with a few words of advice: Take control – fast!

Taking a look at an easy hypothetical mortgage, it quickly becomes evident how difficult the current landscape can be for buyers. For someone who took out a three-year ARM for $200,000 in 2003 to buy a home, for example, the change could go something like this: With a Treasury index, what started with a 4 to 4.5 percent interest rate (stable for three years under terms of the ARM) would have adjusted for the first time this year, likely spiking to 7.5 percent – and adding $400 or so to the monthly payment.

Even with an immediate switch to a fixed-rate mortgage, that buyer would still feel significant pain: closing costs of $3,000 or so (which could be rolled into the new loan) and a fixed rate of 6.5 percent or so would be an improvement, to be sure, but still a significant jump from the introductory ARM rate.

"Before you face that first adjustment, the first thing you need to do is give yourself several months to maneuver and figure out what your options are," says Greg McBride, senior financial analyst at Bankrate.com, a popular personal finance website. "Go pull out your loan documents and see what the index and margins are. It's all spelled out in the documents."

From there, a blizzard of factors and questions must be assessed and answered: How much can you afford? How long do you plan to live in your house? How willing are you to downsize? What is your current lender willing to do for you?

This last point should be analyzed in comparison with other lenders' offers. Experts suggest soliciting rates and terms from three outside lenders to gain perspective on whether the current lender is making a satisfactory offer.

In addition to getting an early head start (Bankrate.com and other sites offer projections and calculators at no cost to help buyers determine what impact an ARM's adjustment will likely have on monthly payments), experts urge homeowners to be realistic in their assessments.

If, for example, you plan on selling your house in a year or so, refinancing would be ludicrous – there would be no chance of recouping the cost.

As for the notion of refinancing a current ARM for a new ARM, forget it. "That's not a good idea, because you're just rolling the dice again," Mr. McBride says. "It's delaying the inevitable, unless you sign a contract with the Yankees or win the lottery."

In recent years, ARMs have become more intricate. In part, the lower upfront payments that adjustable loans carry helped spike homeownership to record levels. To spur even more business, the residential real estate industry began offering more complex ARMs, including ones that require only a minimum monthly payment, much like credit cards, as well as mortgages that have the homeowner pay down interest but none of the principal.

In other cases, the terms of the fixed period vary widely. The interest rate may adjust as soon as one month after the loan starts – and keep changing throughout the life of the ARM.

"It takes a trained financial person, a trained accounting person, and a trained legal mind to understand some of these mortgages," says Susan Wachter, a former assistant HUD secretary in the Clinton administration. "It's complicated."

Even a more traditional version with, for example, a two-year fixed rate can cause problems for homeowners when interest rates are on a steady rise, as they have been of late. The reason is simple, as a report compiled earlier this year by the Federal Reserve spells out: Many buyers don't understand how an adjustable mortgage works, which means they're rarely prepared to – or can't – handle unanticipated higher payment schedules.

Even when they do understand the ARM concept, borrowers tend to underestimate the amount by which their interest rates can change, according to Federal Reserve research. A sizable number of adjustable-rate borrowers don't know the terms of their loans at all.

As homeowners consider their options in the face of refinancing their ARMs, it's worth remembering a bit of old-school advice. "We always recommend the fixed-rate mortgage, because you know what your payments are," says Jeff Blyskal, senior editor at Consumer Reports. "And as you move up in your career, it becomes much more affordable."

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