Farewell to ARMs: The Debt Debacle Should Convince Homeowners To Lock In Their Rates

The debt drama's potential to cause the first large rate hikes in several years should scare some borrowers off from increasingly popular adjustable rate mortgages - but will it?

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Until recently, most observers assumed the era of the adjustable-rate mortgage (or ARMs) had come to an end with the peak of the real estate market.

After all, the mere mention of these loans sparks the fear of foreclosure in the minds of many. ARMs originated in 2003, for example, have proven 117 percent percent more likely to fall into foreclosure than fixed-rate home loans from that year, according to the Center for Responsible Lending. Almost everyone knows someone whose ARM introductory rate reset beyond their ability to pay, or who is trying, unsuccessfully, to refinance the ARM on their upside-down mortgages before rates shoot up. And with rates on 30-year-fixed rate mortgages down in the 4 percent range for much of 2010, there seemed to be no good reason to take an ARM, either for the average home buyer or refinancing homeowner.

Indeed, while ARMs accounted for nearly 40 percent of all loans originated in 2005, that market share had dropped below 10 percent by 2010, according to Fed research.

(MORE: Nearly 1/3 of Americans ‘Highly Unlikely’ to Qualify for a Mortgage)

But this year, even as rates have trended a tad higher than last, there has been an uptick in the popularity of ARMs. The New York Times recently reported that adjustable home loans made up 12 percent of all mortgages originated in the first half of this year, the largest share of since 2008.

Contributing to this increase are buyers who plan to sell or pay their mortgages off before the rate adjusts. ARMs are also attractive to buyers who simply feel they can afford an increase if it comes to pass and see the risk as a worthwhile trade-off for the savings they can realize right away. These borrowers counter the ARM foreclosure-fear factor with a nuanced understanding of what was really wrong with subprime-era ARMs. They also point to the many homeowners who have been pleasantly surprised to find their interest rates actually adjust downwards. Fully-adjustable ARMs have been at or under 5 percent, on average, since spring 2009, according to financial publishers HSH Associates.

But while recent rate history seems to have blunted the fear of ARMs in the minds of prospective borrowers, one current event really ought to refresh that fear, at least among the cautious: the debt-ceiling debacle.

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By now, we all know that the debt ceiling has been raised and the immediate prospect of a U.S. government default has been averted. But the risk of default was always less of a threat to mortgage rates than the risk of the U.S.’s credit rating being downgraded — and that possibility is looking increasingly likely.

If America’s credit rating is downgraded, mortgage rates will rise — potentially by a lot. The Securities Industry and Financial Markets Association projects that a downgrade would force the government to incur an additional $100 billion in borrowing costs annually.  These borrowing costs will be passed on to mortgage consumers in the form of higher interest rates. Additionally, federal mortgage agencies will also be forced to pay higher borrowing costs, which will drive up fees on 90 percent of the mortgages originated nationwide.

Bottom line: Until the country’s debt problems are dealt with in a lasting way, the odds that ARM rates will shoot through the roof remain very high. And any borrowers who are taking ARMs believing that the government won’t let rates go up until the housing market and broader economy are healthy should realize that our dysfunctional government isn’t entirely in control of the matter.