Do You Know Your Loan?

Borrowers With Adjustable-Rate Mortgages Might Not Understand What They've Got

Washington Post, June 3, 2006
By Sandra Fleishman

Pat Smucker knows exactly how much she owes on her house, what the loan terms are, how the interest rate has doubled in the past four years and that the rate could go even higher before her retirement home in Florida is finished.

But then, the Sterling resident has a big advantage over most borrowers: She worked in banking for 33 years before retiring recently. So she's well aware of myriad loan types and terms and the relative risks of new loan products.

Smucker and her husband, Joe, a retired federal government worker, were among the most clued-in home borrowers interviewed at random recently at Reston Town Center. Though their mortgage was the furthest thing from their minds as they cooled down from a bike ride to the mall, the couple agreed to participate in an informal survey of what borrowers know about their mortgage loans.

The sidewalk survey was just a simple quiz. What do you know, and when did you know it? Eight out of 11 mortgage holders knew quite a lot -- a decent percentage, wouldn't you say?

But consumer activists, regulators and industry groups are taking heed of more comprehensive studies that suggest that a growing group of borrowers -- those with adjustable-rate mortgages, or ARMs -- might not understand what they have signed up for. With estimates that perhaps a third or more of borrowers are taking out more risky ARM loans now, compared with less than 7 percent four years ago, the question of what people understand about their loans and whether they will be able to afford them if rates rise has taken on even more importance, according to the experts.

Federal Reserve Board Chairman Ben S. Bernanke and other regulators, for example, have warned that exotic mortgages issued in recent years to less creditworthy home buyers could pose problems if the housing market cools dramatically. And Bernanke testified last week on Capitol Hill about how consumers need more financial knowledge in general to "navigate today's increasingly complex financial services marketplace."

Or, as your mother always told you, what you don't know can hurt you.

Ever-more-exotic types of loans originally marketed mostly to the affluent have become commonplace as borrowers have strived to keep up with ever-increasing house prices. As with traditional ARMs, rates on these loans start out lower than fixed rates but adjust with the market. The newer ARMs may offer borrowers the option to pay only the interest on the loan, or to choose how much principal or interest to pay. The attraction is lower monthly payments. But as these interest-only and "option" loans have become more available, the notion that payments will ratchet up one day and the understanding of how they adjust may be getting lost, experts warn.

"If borrowers do not know their mortgage terms, they may be surprised by the changes in their payments if interest rates rise and thus may subsequently experience financial difficulties," warn the authors of one recent study on borrower awareness done by two Fed economists.

"People just don't understand these new mortgage products," Allen Fishbein, director of credit and housing policy for the Consumer Federation of America, said last week. "And the stakes are much higher now because the terms permit substantial adjustments upward in their mortgage payments." The federation a year ago published a study saying that borrowers, particularly minorities and low-income consumers, were getting inappropriate loans or choosing them for the wrong reasons.

The Reston lunch-bunch survey didn't turn up anyone who was panicked about his loan -- after all, interest rates are still relatively low in comparison with past decades -- but the results were similar to those of the more academic studies.

The Fed economists' report, published this spring, concluded that about 35 percent of borrowers with ARMs didn't know how much their interest rate could jump, or reset, at any one time. And 41 percent of those holding ARMs weren't sure of the maximum interest rate they might have to pay.

Also, the study found that a sizable number of borrowers think they know how high their rates can jump but really don't know.

Borrowers with less education and lower incomes were even less likely to know their mortgage terms, according to Fed economists Brian Bucks and Karen Pence. And nonwhite or Hispanic borrowers were about twice as likely not to know.

The Fed study, though, likely underestimates the problem, according to consumer groups. It was based on 2001 data and thus doesn't account for the wave of interest-only ARMs and option ARMs that has hit since then, activists say.

In the Washington area, interest in the exotic loans has been much higher than the national average, according to LoanPerformance, a real estate information firm.

About half of new mortgages made in the area in January and February were interest-only, and 21 percent were negative amortization, according to LoanPerformance.

Of the 15 individuals and couples quizzed last week at Reston Town Center, six had ARMs.

Three rented, so they didn't qualify for the test.

Another had paid off her mortgage, so she was sitting pretty. (She's not alone. About a third of all homeowners have burned the mortgage.)

Of the 11 in Reston who said they did have a mortgage, five were able to quickly rattle off their terms because their loans are fixed rate, meaning the interest rates won't ever change.

No surprise there. Fixed-rate loans, either for 30 years or 15 years, are the traditional type of mortgage loan in America and the type held by the most borrowers -- about 47 percent.

Of the six interviewees with ARMs, three were up on how high their rates could jump, how much they could increase at any one time and what exactly triggers the rates to change. That's a 50 percent score in the "don't know" column, compared with about 40 percent for the Fed study.

The small sample makes such levels of precision meaningless in statistical comparisons. And, said former banker Smucker, borrowers here generally have a decent grasp of their finances. "In this area, people are pretty smart about these things. They're more knowledgeable here than just about anywhere else, I think," she said.

But that doesn't mean they can always make the best deal or even remember the loan they took, she said. "People are so busy here, they don't have time" to keep track of everything.

Others interviewed on the glorious blue-sky day in Reston also said they could understand how borrowers might not know what they've agreed to.

"I don't find it surprising that the public doesn't understand the loans," said Abhinav Jauhari of Herndon, who is getting ready to close on a single-family house, his first in the United States.

"I find it very confusing," much more confusing that the loan process in India, said Jauhari, 32, a technology professional. He and his wife, Divya, 31, own two houses in that country.

"I think I know what my mortgage will be here. It's a 7-1 ARM," meaning the interest rate is fixed for seven years and then adjusts annually, he said.

"But how much it can go up, I don't know exactly," he added. He also did not know what the rate was indexed to, or triggered by. All adjustable-rate mortgages in the United States adjust according to a publicly published number, or index, but there are a variety of indexes out there, such as those that track Treasury notes and those that track bank lending rates.

The couple, who have a 2 1/2 year-old and a 6-month-old to keep them busy, took the adjustable rate, said Jauhari, because "the prices here are much more than we thought they would be."

Farzad Shirzad, a computer consultant who works in Reston but lives in Silver Spring, also has a seven-year ARM. He and his wife, Sonya, a physician, took the 4.75 percent loan about 30 months ago because it was a way to keep up with the hot market, he said.

The couple had spent three years looking for a house but kept losing to others in the then-omnipresent bidding wars. So they had to build in room for a higher price than they had hoped, using an ARM that reduced the monthly payment.

"We didn't want to be in too risky a loan, say a three-year ARM or a five-year ARM," Shirzad said. "I think seven years at a low rate and a couple years at a high rate will be the worst-case scenario. We figured at the time we took the loan that we would refinance" to a long-term loan at a reasonable rate before the ARM could adjust.

With long-term interest rates at historic lows for the past six years, a number of people who bought with ARMs and have seen their home values catapult have refinanced into 30-year loans, according to the Mortgage Bankers Association. Those who came late to the game, however, can't count on the same kind of price appreciation, industry experts and regulators warn.

"I used to have a 7-30 mortgage," a rate that held for seven years and then adjusted to a new fixed rate for the next 30 years, said Lynn Feinberg of Arlington as she lunched by the main fountain in the Reston plaza. "But when the rates got low enough on the 30-year loans, I switched."

Feinberg's lunch companion, Dorcas Domenico of Reston, said she "refinanced a couple of times when the rates dropped" two years ago. "We're too boring now for your survey, aren't we?" she said.

Robert Foster, a technology worker who lives in Clifton, refinanced three years ago, when rates sank to 5.25 percent. "I think I was just lucky" to get what ended up being the bottom rate, he said.

Foster said he thought about waiting even longer before locking into a 30-year rate, "but I just couldn't imagine 30-year rates ever going lower."

N.L. Jeffries, a security manager who owns a four-bedroom Colonial on a half-acre in Berryville, also moved to a 30-year loan a couple of years ago "because I know better than to take an ARM," he said. "I wanted my costs to be fixed."

While an ARM might be good for those who can't afford the monthly payment but expect their income to grow or who expect to move before the loan adjusts, Jeffries said, "I think some people just go into it because they want that house, and they don't think of the financial implications until it hits them down the road."

An interest-only mortgage "is a big loser," Jeffries said. "It's like you're running a race but standing still. You're never going to make it to the finish line."

Smucker, the retired banker, though, said she willingly agreed to an interest-only loan for her house because she knew what she was getting into.

She recounted how she decided to put her house payments on her home equity line in 2002 rather than taking out a new mortgage. Though the rate on her loan has shot up to 7.5 percent from 3.75 percent since she signed the original deal, Smucker said her home value has also gone up a lot. And she figured she could take the chance that the rates might not escalate beyond her means because the amount she owed was less than $200,000 and her bank offered a very low interest rate that she could track daily.

If the rate had threatened to climb too high, she said, she would have tried to refinance into a more traditional long-term loan. Since it didn't, she and her husband simply paid the loan down as fast as they could.

"We knew we were going to keep it only about three years more. We wouldn't have done it if we knew we were going to be staying because then you're at the mercy of the rates," she said.

Elena Saxon, a customer-support worker from Loudoun County, said she and her husband took out a seven-year ARM because "we didn't plan to be there for the length of the ARM."

Saxon said she doesn't remember the terms on the loan -- "I did when we did it" -- but quickly added that her husband is responsible for that kind of fine print. He "will definitely keep us on top of all those details."

But, she said, she's "not worried" that she will find herself stuck with too-high payments. Now that there's less than five years left on the loan, "we may stay in the area," Saxon said. "But not in that house" if interest rates jump too high.