Interest-Only Mortgages -- Where's the Risk?

How bad is the housing market? How much might slowing home prices impact economic growth? It feels like most pundits writing in the popular press fall into two categories: either they are dismissive of any kind of housing slowdown, or they are alarmists using terms like “bubble” and “crash.”

Let’s look at some actual numbers. At the end of 2005, 17% of all mortgages outstanding were non-amortizing ARM’s, where the borrower pays interest on the debt but not principal for the first several years of the loan. About 1/3 of these loans (6% in total) were so-called “option ARMs,” which allow borrowers to make payments which are less than the full interest due. If the borrower does not pay the full amount due, the extra interest is tacked on to the principal of the loan. After the non-amortizing period ends, the borrower’s monthly payment increases substantially, because at that point the borrower must pay both principal and interest. The interest rate on these loans also resets, usually at the same time the principal must start being repaid. Since interest rates in general are the highest they have been in 5 years, virtually all ARM borrowers would be facing higher rate resets if their loan reset today. For example, a borrower who has a 4.84% interest-only ARM fixed for 5 years (the average outstanding rate, according to Bear Stearns) would start out paying $605 per month on a $150,000 loan. If that loan reset today and principal starting being due, the payment would increase to $1,060 per month.

Rather than just accept the steep increase in payment, the borrower could refinance the current interest-only loan into a new interest-only loan, therefore delaying the time until the principal becomes due. However, because interest rates are so much higher, the borrower still faces a substantially larger payment. Today the available rate for a 5-year interest only loan is 6.39%, according to Freddie Mac. That means the borrower’s payment would rise from $605 per month to $799.

A lot that has been written about interest-only loans has focused on the increased payment when principal becomes due. But this ignores borrower’s options, and therefore misestimates their likely behavior.

There are about $1 trillion in interest-only mortgages outstanding. Using the 4.84% average rate figure, we estimate annual payments from these borrowers of $50 billion. If they all got new loans today, they would be facing payments $66 billion per year. Certainly a sharp percentage increase, but a decrease of $16 billion in consumer spending is only about 0.1% of GDP. We also know that not all borrowers will refinance at once. Most will probably wait until very close to reset to refinance. The average time to reset for all outstanding ARMs is 34 months. So the impact of increased mortgage payments on GDP will be very small in any given year.

The problem won’t come from the average borrower, but from the borrower who stretched to purchase their current home by using an interest-only ARM. How many borrowers are in this situation is not easy to estimate. Some borrowers may have started out stretching but their economic situation has improved since. Now being totally speculative, let’s say that 10% of interest-only borrowers are really stretched and wind up defaulting when their loan resets. U.S. GDP is $13 trillion, so $100 billion is about 0.8% of GDP. If we assume the reset dates for at-risk borrowers is distributed the same as all ARM resets, and we assume the defaults simply subtract directly from GDP, we’re looking at a reduction in GDP growth of about 0.2% each year for the next three years.

We know that mortgage ARM resets are only part of the economic impact that a slowing housing market will have. After running the numbers, I’m hard pressed to say that ARM resets themselves are a big problem.