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Most Americans do not understand how (ARMs) Adjustable Rate Mortgages work here it is in a nutshell. Your teaser rate which can be fixed for 2 years 3 years or 5 years will adjust based on 2 things; a banks margin + an index....In the case of most adjustables that would be the LIBOR INDEX, then there is COSI and COFI and MTA indexes which are all relatively correlated in the same fashion to the FED Funds rate. When the FED moves the FED rate up it also increase the the index that will determine where your adjust can adjust which will be a higher rate. For example in 2003 the LIBOR INDEX was 1.25% lets say you have a 2yr fixed rate 28 year adjustable and your intial rate was a 6.75% your banks margin was 4.25% and the index is 1.25%. You will not adjust out of your teaser rate because after the teaser rate your bank margin plus index is only 5.5%....
Now lets take the same scenario with the FED moving rates up 4 points and you will have this this to look forward to; a bank margin of 4.25% plus and index of 5.5% (the high the LIBOR INDEX reached). Adjustables are capped on how much they can adjust above the intial teaser rate on the first adjustment, 2 points for 2yr fixed 28 year adjustables and 3 points for 3 year fixed 27 year adjustable....your new rate would equal 4.25+5.5=9.75%. This would allow your bank to adjust both 2 yr and 3 yr teaser rates to the maximum of their respective caps. Higher rates mean higher rate of default unless your income is adjusting upward hundreds of dollars to offset this hit to your mortgage payment which it is not.
In a nutshell the FED giving us higher rates means they are giving Americans higher payments on various forms of debt mortgages the largest, credit cards, and lines of credit. Remember the FED Rate also controls Prime rate which is equal to the FED FUNDS rate plus 3%.....currently the FED RATE Is 3.5% plus 3% which gives you prime rate at 6.5% most credit cards are also pegged to prime rate with a bank margin. Higher rates means higher defaults this is know to the FED so why I ask would a 4 pt rate hike in the largest American Debt/Housing boom be a good thing for achieving the "American Dream?"
I got a 5/1 ARM in 2001 at ~5.5% initially and an annual 2% cap on the adjustment (have since sold the place). Initially I thought 2% was just the max it could go up, so chances are it would actually would go up by less. When I looked at how the rate was indexed (against the LIBOR like in your post), it appeared that even if rates stayed contant, I would have adjust by the max (2%) at the end of 5 years. It was our starter home and we did end up selling (and getting a fixed rate) before the thing ever adjusted on us.
ReplyDeleteAnother issue is, you see a 2% increase in your rate and 2% doesn't sound like much, but when I did the math, I was surpised at how much my payment was going to go up. Basically, if you had an interest-only mortgage (obviously a bad idea, but makes the math easier) and a 4% initial rate, a 2% adjustment would increase the monthly payment by 50%!. They should teach this stuff in school.