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ARMed and Dangerous: Why We Should Abolish Adjustable Rate Mortgages

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The second biggest financial debacle facing Americans after the retirement crisis is the mortgage crisis. While many in the media have blamed the failures on reckless borrowers, the real driver of the crisis is lawless banks offering "bait-and-switch" adjustable rate mortgages.

While I've never seen an accurate analysis of the mortgage meltdown, my take is that before recklessness ruled in the 1980s, folks with no credit or poor credit ratings had to build a good rating to be approved for a credit card or mortgage. In the same fashion that credit card issuers instead decided to profit by charging these folks outrageous interest rates, mortgage banks lured borrowers into adjustable rate mortgages. The increase in ARM rates is NOT necessarily based on the underlying prime rate but an arbitrary "reset" that's not only not disclosed to the borrower -- but usually, if not always, increases. A survey of homeowners by the AFL-CIO in 2007 indicated that 75 percent had no idea what their new monthly payment would be after the reset -- even when an increase was disclosed it was in the form of "points", not monthly payments. More than 30 percent of loans that reset weren't based on the raise in the prime rate and the average monthly increase consumed 10 percent of after tax incomes.

For many borrowers, their interest rate could increase by three percentage points in as little as two years -- causing monthly payments to increase by more than 30 percent. That's what happened in my household in 1989. If my husband hadn't gotten a significant raise, I would have had to work a second job -- a challenge when helping to raise a three-year-old son and a daughter-on-the way.

While I'm a huge fan of Elizabeth Warren, the brains behind the Consumer Financial Protection Bureau, I fear that the Bureau has either been pressured by the banks not to tell the truth about the risks or they don't understand them. While the CFPB recently launched a new portion of its Web site called Ask CFPB, their description of ARMs simply says that "part of the interest rate you pay will be tied to a broader measure of interest rates, which goes up when the index of interest rates moves higher," rather than spelling the potentially unaffordable rise in payments.

Why is this information vital? Because if you wind up being stuck with an ARM you very likely won't get your mortgage modified because reckless banks aren't forced to change their ways but are simply "incentivized" to do so. The Home Affordable Modification Program (HAMP) simply provides "cash payments and financial subsidies" to help the lender lower the monthly payment to no more than 31 percent of the borrower's gross income. While JP Morgan and Bank of America are at risk of being "punished" by losing $131 million in incentive payments if their work with delinquent homeowners doesn't improve, why would this piddly incentive matter, given that JP Morgan reported net income of $3.7 billion in the fourth quarter of 2011. Not surprisingly, despite President Obama's pledge in February 2009 to help as many as 7 to 9 million borrowers, thus far HAMP has resulted in only about 1 million loan modifications.

Very likely the finger of blame for recklessness shouldn't be pointed at President Obama but at Treasury Secretary Tim Geithner and former National Economic Council director Larry Summers, "I think the president really wanted to do something aggressive," former FDIC chairwoman Sheila Bair told the National Journal. But Larry and Tim "were focused on the big financial institutions."

Until we get reform, spread the word to avoid these mortgages. With a fixed rate loan, you can always refinance when the interest rate moves lower, although you should probably wait until it's at least two percentage points lower -- otherwise "closing costs" will eat up the benefits.

I provide other tips in a previous blog.