Sunday :: Jul 25, 2004

Why Raising the Interest Rates Hurts

by Mary

One of the dangers that comes with higher interest rates combined with the hot housing market is how it will affect those with Adjustable Rate Mortgages (ARMs). As housing prices have risen much faster than the rate of inflation the past few years, many people have turned to ARMs in order to afford their home purchases. And ARMs seemed like a good deal, because the interest rates were so low. But now, as Greenspan tries to put the brakes on the economy by increasing interest rates, many home owners will find themselves badly stretched as their housing expenses overtake their ability to pay for their purchase. Economists are starting to worry about what this will mean to the economy.

But as homes become increasingly difficult to afford and higher interest rates make fixed mortgages more expensive, more homebuyers are taking out more risky adjustable mortgages, for which the rate varies.

"People are saying: 'The only way I can afford to get a house is to get an adjustable-rate mortgage,'" said Joseph McKenzie, deputy chief economist at the Federal Housing Finance Board, adding that there are no signs yet of significant price declines in the booming US housing market. Adjustable mortgages are initially cheaper than fixed mortgages, making it easier for consumers to buy homes. The percentage of adjustable mortgages taken out has more than doubled over the past year, rising to 36 per cent of all loans closed at the end of May, according to the housing finance board.

Economists say consumers typically favour adjustable mortgages in periods of rising interest rates because fixed mortgages become more expensive. "The same thing happened in 1994 and 1999," said Doug Duncan, chief economist at the Mortgage Bankers Association. "The pattern is repeating itself." However, mortgage analysts are worried by the increasing numbers of low income borrowers with poor credit quality that are taking out adjustable loans. The payments on these loans will increase as interest rates rise, possibly creating financial stress.

"There are some borrowers who are selecting these products not out of desire but out of necessity and it may come back to haunt them," said Keith Gumbinger, vice-president at HSH Associates, an independent mortgage research firm. "Some of the products that are being originated today will turn into the foreclosures of tomorrow.

The consequences to the individual homeowners that are stretched beyond their means is easily understood: they stand to lose their homes through foreclosure. But what will that mean for the housing market? Is there a bubble waiting to burst?

Mary :: 10:32 AM :: Comments (8) :: Digg It!