Expect a home refinancing boom in '07

By Bankrate.com

2007 will bring an unusual refinancing boom as hundreds of thousands of borrowers bail out of their adjustable-rate home mortgages while the getting is good.

On top of that, sellers and buyers will grapple with stagnant or falling house prices in some markets. And it's anyone's guess what course the Federal Reserve Board will take.

Like the twin strands of a DNA helix, house prices are intertwined with the fate of adjustable-rate mortgages, or ARMs. That's especially true for two types of adjustables: interest-only mortgages and a subset called pay-option ARMs. The main appeal of these nontraditional mortgages is that they have extra-low monthly payments, allowing people to buy more house than they otherwise could afford. That benefit brings a trade-off: Borrowers build up equity slowly or, in some cases, actually lose equity in the house with every monthly payment. (See "How to avoid going underwater on a mortgage.")

In a self-reinforcing cycle, rapidly rising house prices pushed buyers into getting pay-option and interest-only ARMs, while the popularity of these loans sent house prices even higher. Definitive estimates of the popularity of nontraditional mortgages are hard to come by, but it is believed that in some markets, especially in coastal California, around half or even more of new-home buyers took out interest-only or pay-option ARMs in 2005 and 2006.

Minimum payment might not cover interest

Although nontraditional mortgages start out with low monthly payments, they are sensitive to rising interest rates. A pay-option ARM might have an initial rate of 1.9% that lasts only a month. The rate can rise every month thereafter and could exceed 7% within six or seven months. The sneaky thing about pay-option ARMs is that, although the rate might rise every month, the minimum monthly payment doesn't. The minimum monthly payment changes just once a year. That means that the minimum payment often doesn't even cover the interest charged, so that the loan balance rises.

Expecting to pay off a mortgage that way is like eating a dozen doughnuts every morning and expecting to lose weight by walking a mile every evening.

Mortgage bankers believe a steady influx of homeowners will refinance their nontraditional mortgages into something less exotic in 2007. A lot of them will refinance into 30-year, fixed-rate mortgages. Others will get hybrid ARMs, such as the 5/1 ARM, which has a relatively low introductory rate that lasts for five years, then adjusts annually thereafter. Hybrid ARMs are popular among people who expect to sell their houses within a few years.

Median house prices began falling on a year-over-year basis in the fall, and the National Association of Realtors predicts that falling prices will persist into January and maybe February "before gaining positive traction," as an association news release puts it.

"Our sense is that home sales may have reached a low in August," says the Realtors' chief economist, David Lereah, adding that he expects the pool of unsold houses to shrink early in 2007 "to the point where home prices will rise, but at a slower pace than historical norms."

Such a real estate environment is called a buyer's market because the buyers call the shots. The buyer's market is going to present a big problem in 2007 for those unfortunate souls who have nontraditional mortgages with rising rates. The combination of falling house values and rising loan balances can make it impossible to refinance -- because you can't get a loan for more than the house is worth -- and hard to sell because the lender will demand the full loan amount, even if the selling prices minus real estate commissions and other costs comes out to less than the loan balance.

On top of all this, the Federal Reserve's course in 2007 is more unpredictable than usual. In 2004, everyone knew the Fed was going to start raising rates. In 2005, everyone knew the Fed was going to keep raising rates. In 2006, everyone knew that the Fed was going to stop raising rates. There is no consensus as to what the Fed will do in 2007 -- whether it will start cutting short-term rates, hold rates steady or raise them a couple of more times.

Most economists predict that long-term mortgage rates will rise gradually through 2007. The same economists predicted a similar yearlong rise in 2006 and were caught by surprise when rates on 30-year mortgages fell more than half a percentage point over the summer. (In fact, rates hit a 14-month low in December.)

The big questions for 2007

What's going to happen to mortgage rates? No one can predict the movement of interest rates accurately. It's relatively safe to predict that rates will rise in 2007, but no one knows how far they will rise and whether the increase will be slow and steady through the year or whether most of the increase will take place in just a few months, with rates being relatively flat the rest of the year.

And the pundits could be wrong -- rates could fall in 2007.

So, should I refinance in 2007? The answer to that depends on many factors. If you want to refinance strictly to get a lower interest rate, you're probably better off doing it sooner rather than later.

There are other reasons to refinance. Some people refinance to get rid of mortgage insurance. Others do it to pay off high-rate home-equity lines of credit and consolidate all that debt into one mortgage loan. Still others look at refinancing as a way to escape rising interest rates on adjustable-rate mortgages, particularly on interest-only and pay-option ARMs.

If you decide to refinance for one of the above reasons, discuss it with a trusted loan officer or mortgage broker to make sure you have all the facts you need. You might find, for example, that it costs more in the long run (but less in the short run) to consolidate all your debt into one mortgage.

Then when should I refinance? Refinance your mortgage when you're ready to do it. In other words, if it makes financial sense to refinance at a certain time, go ahead and do it. Don't wait for rates to fall further. You can't know if you grabbed the rock-bottom rate until after the fact, so don't even try.

When it comes to mortgages, getting a good rate is good enough. The world won't end if you don't get the absolute best rate.

Should I wait before I buy a house? Waiting for home prices to hit bottom is just like waiting for interest rates to reach their nadir. You can't count on timing the market correctly. When you find the right house at an acceptable price, go ahead and get it. If house values in the neighborhood fall after that, well, you didn't buy the house just to sell it a few months later, right? The house is almost assured of appreciating over the next few years, even if its value falls for a while at first.

This article was reported and written by Holden Lewis for Bankrate.com.