The first interest rate hike by the Federal Reserve in nearly a decade means consumers can no longer take advantage of a zero interest rate environment. Particularly challenged will be homeowners who have adjustable rates and stand to face higher mortgage payments.
Record low mortgage rates are set to be thing of the past as the Fed raised rates by 0.25%, which appears to be a nominal amount initially. Of course, consumers need to consider the cumulative effect of the central bank's decesion to increase rates periodically over a span of two to three years. The consecutive rate hikes will affect homeowners with adjustable rate mortgages when they reset, which typically happens once a year.
“The initial interest rate move is very modest and consumers will see a corresponding increase in their credit card and home equity line of credit rates within one to two statement cycles,” said Greg McBride, chief financial analyst for Bankrate, the North Palm Beach, Fla. based financial content company. “The significance is in the potential impact of whatever interest rate hikes are put into effect over the next 18 to 24 months.”
The Fed will continue to raise rates several times next year since yesterday’s move is not a “one and done” move, said Robert Johnson, president of The American College of Financial Services in Bryn Mawr, Pa. The Fed will likely follow with a series of three to four rate increases in 2016 if the economy continues to improve. The central bank could raise interest rates to a total of 1.0%, which will cause mortgage rates, auto loans and credit card rates to rise in tandem.
Adjustable rate mortgages, or ARMs, are popular among many younger homeowners, because they typically have lower interest rates than the more common 30-year fixed rate mortgage. Many ARMs are called a 5/1 or 7/1, which means that they are fixed at the introductory interest rate for five or seven years and then readjust every year after that, said David Reiss, a law professor at Brooklyn Law School in N.Y. The new rate is based on an index, such as the prime rate or the London Interbank Offered Rate (LIBOR), as well as a margin on top of that index. LIBOR is used by banks when they are lending money to each other.The prime rate is the interest rate set by individual banks and is usually pegged to the current rate of the federal funds rate, which the Fed increased to 0.25%.
The prime rate is typically used more for home equity lines of credit, said Reiss. LIBOR is typically used more for mortgages like ARMs. The LIBOR "seems to have had already incorporated the Fed's rate increase as it has gone up 0.20% since early November," Reiss said.
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“The prime rate is influenced by the Fed’s actions,” Reiss said. “We already see that with Wednesday's announcement that banks are increasing prime to match the Fed’s increase.”
The main disadvantage of an ARM is that the rate is only fixed for a period of five or seven years unlike a 30-year fixed rate mortgage, which means that monthly payments could rise quickly and affect homeowners on a tight budget.
Over the course of the next couple of years, the cumulative effect of a series of interest rate hikes could take an adjustable mortgage rate from 3% to 5%, a home equity line of credit rate from 4% to 6% and a credit card rate from 15% to 17%, said McBride.
“This is where the effect on household budgets becomes more pronounced,” he said.
Refinancing Sooner Rather Than Later
Homeowners should start researching mortgage rates and refinance out of ARMs and lock into a fixed rate, said McBride. The 0.25% rate increase equals to a payment of $0.25 for every $100 of debt.
Since many factors impact the interest rates of mortgages, consumers need to examine the actual benchmark used by their lender since some existing interest rates already priced in some of the anticipated rise in the federal funds rate, said Reiss. While ARMs expose the borrower to rising interest rates, they typically come with some protection. Interest rates often cannot rise more than a certain amount from year to year, and there is also typically a cap in the increase of interest rates over the life of the loan.
An ARM might have a two point cap for one year increases if the introductory rate of 4% increased to 6% in the sixth year of a 5/1 ARM, he said. That ARM might have a six point cap over the life of the loan, which means a 4% introductory rate can go to no higher than 10% over the life of the loan.
Based upon the current Fed increase of 0.25%, a homeowner with a $200,000 mortgage would pay an additional $40 a month or $500 a year when the rate resets.
“While this is not chump change, it is also not immensely burdensome to many homeowners,” Reiss said. “The bottom line is that it is worth figuring out just how your ARM works so you can understand what your worst case scenario is and then plan for it.”
Since rates are expected to continue rising, refinancing into a fixed rate mortgage now can prevent further increases, said Jonathan Smoke, chief economist of realtor.com, the San Jose, Calif. real estate service company. Fixed rates rose slightly from last week and "actually declined slightly after the Fed's announcement, so rates remain very low," he said.
Since ARMS have been much lower than fixed rate mortgages, refinancing from an ARM to a fixed rate would likely push payments higher.
"Given forecasts for higher rates in the years ahead, that lower payment today will eventually exceed what a fixed rate now could lock in for the rest of the loan," Smoke said. "By 2017 or 2018, rates will likely be 2% or higher than they are today."
The 30-year fixed mortgage rate is 4.09% while a 5/1 ARM is 3.42% and a 7/1 ARM is 3.65%, according to Bankrate.com’s national survey of large lenders.
Refinancing an ARM is the right move currently if you are planning to live in your home for more than a year or two after the ARM expires, said Michael Goodman, a New York-based CPA.
Waiting until rates have already risen to refinance means, “you will be worse off generally speaking,” he said. “If you think you will be moving before or within a year or two of the ARM expiring, then the rate changes do not matter to you.”
Interest rates remain a key factor for the real estate industry as the amount of demand is largely based on lower borrowing costs, which allow for more consumers to be approved for mortgages, said Larry Link, president of Level Group, a NYC residential real estate firm.
“The most important thing to keep in mind is that rates are still low and will likely remain low for the foreseeable future,” he said. “If you look back over the last 10 or 20 years, mortgage rates were anywhere from 50% to 100% higher than they are right now.”