It Will All Hit the Fan in 2007, Part 7

I've discussed a bunch of signs that bode ill for the U.S. economy in 2007.

But here's the big bad event lying on the horizon for the U.S. economy:

Payments for $1 trillion in Adjustable Rate Mortgages (ARMs) will be adjusted by the end of 2007. They will adjust upwards. By a lot.

Over the past two years, a large portion of home purchases have been made using ARMs.

There were 2 main reasons why ARMs were preferred over 30-year fixed-rate mortgages:

1) Short-term interest rates were much lower than long-term interest rates, so the monthly payments for an ARM were substantially lower than for a 30-year fixed-rate mortgage.

2) People could qualify for a larger mortgage than they could with a 30-year fixed-rate mortgage.

Both of these situations have changed.

Now the pigeons are coming home to roost.

Short-term interest rates have skyrocketed since July of 2004, as the Federal Reserve began a string of 15 interest rate hikes, raising the Federal Funds rate from 1.00% to 4.75%.

Some people are in for a rude awakening when their ARMs and interest-only loan payments increase by up to 100%.

The Washington Post describes a real-life example of this scenario. Here's an excerpt from the article:

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Mahesh Desai, 38, who sells software, decided that because interest rates were about to rise, it was time to refinance his house in Darnestown. He had a three-year, adjustable-rate loan at 3.625 percent, and he knew from news reports that rates that low were coming to an end.

"I'm still going to have sticker shock in my next payment, but I've enjoyed lower rates for a while," Desai said. "Guess the party's coming to an end."

His new rate is 6.625 percent, and the monthly payment will jump 72 percent. It is an interest-only loan, but he will be pressed to afford the new payment, even without paying down the principal.

"I'm going to work harder and sell more," he said. "I don't have a choice."
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Even when Mr. Desai did something smart (refinancing his ARM), he did it in a dumb way (taking out an interest-only loan instead of a 30-year fixed).

And I don't think Mr. Desai's case is the exception.

Scary.

Links to previous "It Will All Hit The Fan in 2007" posts:
Part 1, Part 2, Part 3, Part 4, Part 4 (Addendum), Part 5, Part 6