Tag Archives: prime rate

Rates up in ARMs

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AgnosticPreachersKid

Marriner S. Eccles Federal Reserve Board Building

TheStreet.com quoted me in Fed Hike Means Adjustable Rate Mortgages Will Rise and Increase Monthly Payments. It opens,

The first interest rate hike by the Federal Reserve in nearly a decade means consumers can no longer take advantage of a zero interest rate environment. Particularly challenged will be homeowners who have adjustable rates and stand to face higher mortgage payments.

Record low mortgage rates are set to be thing of the past as the Fed raised rates by 0.25%, which appears to be a nominal amount initially. Of course, consumers need to consider the cumulative effect of the central bank’s decision to increase rates periodically over a span of two to three years. The consecutive rate hikes will affect homeowners with adjustable rate mortgages when they reset, which typically happens once a year.

“The initial interest rate move is very modest and consumers will see a corresponding increase in their credit card and home equity line of credit rates within one to two statement cycles,” said Greg McBride, chief financial analyst for Bankrate, the North Palm Beach, Fla. based financial content company. “The significance is in the potential impact of whatever interest rate hikes are put into effect over the next 18 to 24 months.”

The Fed will continue to raise rates several times next year since yesterday’s move is not a “one and done” move, said Robert Johnson, president of The American College of Financial Services in Bryn Mawr, Pa. The Fed will likely follow with a series of three to four rate increases in 2016 if the economy continues to improve. The central bank could raise interest rates to a total of 1.0%, which will cause mortgage rates, auto loans and credit card rates to rise in tandem.

Adjustable rate mortgages, or ARMs, are popular among many younger homeowners, because they typically have lower interest rates than the more common 30-year fixed rate mortgage. Many ARMs are called a 5/1 or 7/1, which means that they are fixed at the introductory interest rate for five or seven years and then readjust every year after that, said David Reiss, a law professor at Brooklyn Law School in N.Y. The new rate is based on an index, such as the prime rate or the London Interbank Offered Rate (LIBOR), as well as a margin on top of that index. LIBOR is used by banks when they are lending money to each other.The prime rate is the interest rate set by individual banks and is usually pegged to the current rate of the federal funds rate, which the Fed increased to 0.25%.

The prime rate is typically used more for home equity lines of credit, said Reiss. LIBOR is typically used more for mortgages like ARMs. The LIBOR “seems to have had already incorporated the Fed’s rate increase as it has gone up 0.20% since early November,” Reiss said.

“The prime rate is influenced by the Fed’s actions,” Reiss said. “We already see that with Wednesday’s announcement that banks are increasing prime to match the Fed’s increase.”

The main disadvantage of an ARM is that the rate is only fixed for a period of five or seven years unlike a 30-year fixed rate mortgage, which means that monthly payments could rise quickly and affect homeowners on a tight budget.

Over the course of the next couple of years, the cumulative effect of a series of interest rate hikes could take an adjustable mortgage rate from 3% to 5%, a home equity line of credit rate from 4% to 6% and a credit card rate from 15% to 17%, said McBride.

“This is where the effect on household budgets becomes more pronounced,” he said.

Homeowners should start researching mortgage rates and refinance out of ARMs and lock into a fixed rate, said McBride. The 0.25% rate increase equals to a payment of $0.25 for every $100 of debt.

Since many factors impact the interest rates of mortgages, consumers need to examine the actual benchmark used by their lender since some existing interest rates already priced in some of the anticipated rise in the federal funds rate, said Reiss. While ARMs expose the borrower to rising interest rates, they typically come with some protection. Interest rates often cannot rise more than a certain amount from year to year, and there is also typically a cap in the increase of interest rates over the life of the loan.

An ARM might have a two point cap for one year increases if the introductory rate of 4% increased to 6% in the sixth year of a 5/1 ARM, he said. That ARM might have a six point cap over the life of the loan, which means a 4% introductory rate can go to no higher than 10% over the life of the loan.

 Based upon the current Fed increase of 0.25%, a homeowner with a $200,000 mortgage would pay an additional $40 a month or $500 a year when the rate resets.

“While this is not chump change, it is also not immensely burdensome to many homeowners,” Reiss said. “The bottom line is that it is worth figuring out just how your ARM works so you can understand what your worst case scenario is and then plan for it.”

Reiss on Being Financially Overextended

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US News & World Report quoted me in 5 Signs You’re Financially Overextended. It reads in part,

 Are you managing your debt? Or is it managing you? If you’re stuck in a money quicksand trap, you may not even realize at first that you’re in a financial predicament, especially if you’re sinking slowly and have been poorly managing your cash for a long time.

But if you suspect your debt is a disaster in the making, there’s no need to wait and see if your financial life will someday implode. If you’re pushing your finances to the limit, the signs are already there that you’re overextended. Just look for them. And if you spot one, don’t ignore it. Here are five of the biggest clues that trouble is coming.

*     *     *

5. You’ve created opportunities that could make you overextended. If you have a lot credit cards or lines of credit you rarely use, you could, in theory, end up spending a lot of money and getting yourself into trouble that way, but having those lines open isn’t itself a bad sign. It’s a sign that you have good credit, and your creditors trust you. Still, it’s good to remember that if you aren’t monitoring yourself, you could ultimately max out and find yourself buried in credit card debt.

At least in that scenario, you have control over what may or may not happen. Some homeowners, however, put themselves at risk for becoming overextended when they get an adjustable rate mortgage or a home equity line of credit in which the interest rate “may float with some kind of index like the prime rate or [London Interbank Offered Rate],” says David Reiss, professor of law and research director at the Center for Urban Business Entrepreneurship at Brooklyn Law School in Brooklyn, New York.

“So if interest rates rise dramatically, the home equity line of credit can become unaffordable,” he says. “Interest rates have been very low for some time, so homeowners are not focusing on this risk, but if they were to rise – and they can rise suddenly – homeowners may face a rude awakening.”

In which case, you may want to refinance and position yourself to avoid becoming financially overextended if the interest rates someday jump. Because what happens to anything when it’s stretched beyond its limits? It – or you – will snap.