Foreclosure: Can’t Pay, Can’t Refinance, Can’t Sell
Call it the reset jitters.
Lenders, mortgage investors and financial regulators are concerned about the ability of millions of homeowners to handle the potentially painful payment spikes coming on loans they took out during the height of the housing boom.
A question that many homeowners are asking today is how big will the payment reset shock on adjustable rate mortgages likely be?
How many or how few homes will go into foreclosure when borrowers with an adjustable rate mortgage face a “can’t pay, can’t refinance, can’t sell” situation if real estate prices go down when their adjustable rate mortgages recast to significantly higher payments.
The phenomenon of "layered risk" is where high cost loans are layered with multiple features such as interest only requirements, prepayment penalties, option payments where the borrower can choose each month whether to make a payment that will amortize the loan, pay interest only or make a minimum amount that will add interest on to the principal due. Such layering has the potential of increasing rate shock. Lenders are also offering low initial "teaser" rates which adjust to higher rates after the initial "introductory" period. In the latter case payments are nearly guaranteed to increase even if interest rates in general do not.
Interest rates for sub-prime ARMs are usually tied to the London Inter-Bank Offer Rate (LIBOR) with a margin of about 5.5 percent added on. The LIBOR has increased from 1.21 percent in January 2004 to 5.45 percent in April 2007. While many ARMs have rate caps that limit the amount that a rate can adjust on each anniversary and over the life of the loan, many sub-prime loans do not—or else have caps that allow very large increases. Even a typical 2 percent cap on a $150,000 loan would allow an increase in the monthly payment of $212.
A study quoted by a Federal Reserve report found an estimated 35 percent of ARM borrowers did not understand the maximum amount their rate could rise at one time or even how to calculate what the maximum rate would be. Another survey by Public Opinion Strategies found that lower-income borrowers did not think that traditional mortgages were an option for them and were also less informed about reset shock and the debt risks.
Borrowers with prepayment penalties and minimum equity may be unable to refinance out of a loan that, once it readjusts, they can no longer afford. Most studies show that up to 1 million households are in danger of losing their homes through foreclosure over the next five years because they will not be able to afford new payment levels and will owe more on their homes than they can recover through a sale or refinance. Most agree that the impact of rate reset shock may be concentrated in certain metropolitan areas, neighborhoods and among certain demographic groups. This might possibly magnify the impact as forced sales and foreclosures flood the market and further drive down prices.
