Explaining Interest Rates

What do you think of when you hear that "the Fed has raised rates?"

While most people recognize that this may not be a good thing, they may not fully understand how this affects them. But as rates have slowly gone up a small percentage at a time, over the last few years the total of those increases have been substantial. As a result, homeowners with adjustable rate mortgages and equity lines of credit may have seen their payments double. Even homeowners with fixed-rate mortgages have been affected, with higher interest rates making it more expensive to purchase or refinance a home.

The problem is that average personal incomes do not grow much each year. Homeowners who took advantage of low adjustable rates a few years ago may no longer be able to afford their payment. People base their lifestyles on their mortgage payment, which is usually a family's largest monthly payment, and so doubling that payment is certain to cause some sort of a financial crunch.

As a result, bankruptcies and foreclosures are becoming more common. To add insult to injury, many people who find themselves in this situation think that they can sell their homes at a nice profit only to find out that homes are no longer increasing in value as fast as they had been. In fact, realtors and appraisers across Northern New Jersey have described the real estate market as "flat" since the Summer of 2005. Now homes are staying on the market longer and selling for much less than homeowners expect.

Another problem is that many people purchased homes recently and took out mortgages for 100% of the home's value. They expected home values to go up as fast as they had been, and the plan was to refinance maybe only one year later. What happens is that if the mortgage amount stays the same but the home's value goes up, the mortgage is now less than 100% of the home's value. The lower that percentage goes, either by paying down the mortgage or through increased home value, available interest rates are lower and that means lower monthly payments. Instead, however, flat home values have reduced or eliminated this possibility, sticking many homeowners with much larger payments than they expected to have.

Fortunately, there is a source of relief. There is a relatively new type of mortgage program called a Pay Option ARM, which may even be an alternative to bankruptcy or foreclosure. The program provides homeowners with options that can preserve lifestyles when interest rates are up, so that the American Dream of homeownership remains when interest rates are back down again.

The way a Pay Option ARM, or POA, works is that it is an interest-only adjustable rate mortgage with four payment "options" per month. When times are good, paying more than just interest reduces the principal balance. However, when times are bad you have an "option" to pay the minimum, which is only a portion of the interest and which may make your monthly mortgage payment hundreds or even thousands of dollars less than you are accustomed to. Used correctly, this product can obviously be a powerful financial tool when times get tough.

The potential downside to a POA is that not paying at least the interest in any given month accrues deferred interest, causing an increase in the principal balance. Then when the ARM period expires, the POA converts to a 30-year fixed loan based on the remaining principal balance, which includes any unpaid interest. In other words, you still have to eventually pay all of the principal and interest back. Because it may be too tempting to keep paying the absolute minimum, this product does require discipline and is therefore not for everyone.

The bottom line is that you might want to consider a POA if purchasing a home otherwise seems unaffordable, or if bankruptcy or foreclosure otherwise seem unavoidable, or simply if your current adjustable rate mortgage payment consumes significantly more of your monthly budget than it used to. After all, the next time you hear that "the Fed has raised rates" you know that these conditions are about to become worse, not better.

Vivian Gaspar is in the business of "Funding American Dreams" through business capital/loans, commercial mortgages, investment properties, residential mortgages, reverse mortgages, cash flow for the unemployed, and personal credit repair. For more information about her products and services, or to schedule Vivian as a guest speaker for your organization, call 800-899-1946 or visit www.VivianGaspar.com.