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Exploding Loans
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Exploding Loans
Whenever mortgage rates rise, it's worth exploring alternatives to the standard, fixed rate products. Sometimes this expedition is fruitful, and other times leads to an excess of optimism over good sense.
On any historical basis, the recent rise in mortgage rates is no more than a bottom-bounce. The 8.00-8.25% (at no point, one origination prices) prevailing since early March is "high" relative to the 7.00% of last winter and part of 1993, but anything in the eights has been a low rate since the Johnson administration.
Never mind: lots of people are off on a deal safari anyway.
The standard alternatives to fixed rate loans are adjustable ones. ARMs come in two flavors: money market and hybrid.
The money market jobs adjust anywhere from monthly to annually and provide the lowest start rate in exchange for the risk of rapid adjustment. The hybrids are fixed for three to ten years and then turn into money market ARMs. The hybrids' longer fixed initial period is safer than the money market ARMs, but isn't as cheap.
Borrowers discover in only a few minutes that today's ARM-to-fixed spreads are too narrow to be useful. The first adjustment on the money market jobs will ruin the "teaser" advantage, and hybrid prices are almost the same as fixed ones.
However, out there beyond the ARM, there is one more beat-the-fixed temptation, priced today about 7.50%. Marketed under different euphemisms -- "7/25", "Seven Year ARM", "Super Seven" -- these loans are fixed for seven relatively cheap years, and then convert permanently to the 30-year mortgage rate prevailing at the time of conversion, plus a half percent.
The innocent names for these loans avoid mention of explosive devices buried in fine print at the seventh year. The events in question are known in the mortgage business as "balloon" and less kindly, "bullet", as in payment.
If the "convert to" rate happens to be five percent higher than the rate you started with, you get a notice telling you where to send the entire unpaid balance. Balloon. Bullet. Right now, no exceptions.
Let's suppose the rate adjusment is okay, but you happen to have a second mortgage or home equity line of credit. If you can't pay it off from ready cash at adjustment time, same balloon deal: pay us now. Bang. Moved out and rented it? Boom.
Standard rationalization: "Well, seven years is a long way off, and 12.00% is mighty unlikely; and if I'm wrong, I'll just refinance."
Will you, really. Let's suppose that during year five, you're still in the house, and there has been a little oops-a-daisy in the Middle East, and mortgage rates are cruising through 11.00% on the way up. What will you do? Refinance at 11.00% (if you qualify)? Sell into a dead real estate market? Sit, shake, and hope the world returns to normal in 18 months, remembering that mortgage rates were 12.00% or higher for the six straight years 1979-1985?
Also remembering the "high" 8.00% you could have had in the first place?
These loans are a good idea only if you are certain to be out of the house before the balloon risk -- way before) -- or are rich enough to make the balloon payment if you are wrong.
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