LIBOR could make your ARM more costly

Percent sign in trap

If you have an adjustable-rate mortgage that's about to reset, your payments could go higher than you expect because of the credit crisis.

The problem is a financial index called the London Interbank Offered Rate, or LIBOR. It's what banks often charge each other for unsecured loans.

During the credit crisis, banks have been reluctant to lend money to each other because of all the bad loans they're carrying on their books. They don't want to lend money to the next bank to go bust.

As you might expect, they've demanded higher interest rates on the loans they do make, and so LIBOR has soared.

In 2004, when many borrowers took out their current adjustable-rate mortgages, or ARMs, the one-year LIBOR rate was hovering around 1% to 2%. Now it's above 4%.

About 6 million mortgages, including 41% of prime, adjustable-rate mortgages and virtually all subprime home loans, are tied to LIBOR, according to First American CoreLogic in Santa Ana, Calif.

ARMs base their initial monthly payments on an introductory interest rate that can last for as long as 10 years or as little as one month. Two to seven years is most common.

Then the interest rate resets once or twice a year to reflect what's going on in the credit markets. If interest rates are higher than when you took out the loan, you can expect your rate to go up.

The new, adjustable interest rate is calculated by taking a financial index such as LIBOR and adding a fixed number of percentage points, called the margin.

How do you know if your mortgage is tied to LIBOR?

Look at your mortgage document. The top of the first page states whether it's an ARM and whether LIBOR is the index. The type of LIBOR used --- usually six months or one year -- also will be specified.

Go to the section of the document on interest rates and monthly payment. That section tells you when your interest rate will change for the first time and how often it will change after that.

The section also says which published LIBOR rate applies to your mortgage. Many loan payments are based on the LIBOR rate disseminated one month before the adjustment date.

In this case, your mortgage document may say: "The most recent index figure available as of the first business day of the month immediately preceding the month in which the change date occurs is called the current index."

Say you have a $200,000 mortgage and an ARM with an introductory rate of 5%. Your monthly payment for principal and interest would be about $1,070.

If your mortgage readjusts to LIBOR plus 3 percentage points -- a pretty typical margin for prime loans -- your new payment would be $1,330 a month, a 24% increase.

Pushing LIBOR back to 3% would reduce the increase to more like 10%, a reset most homeowners would have a much easier time dealing with.

That's a major reason the government is pumping money into banks and encouraging them to resume lending to each other. It wants to lower LIBOR.

Craig Campbell and Shahin Rostami, an Irvine Calif., couple, are so worried that LIBOR won't fall and they'll default on their mortgage that they've put their house on the market and are considering moving to a rental home.

For the past three years, they've been paying 4.625% on an interest-only loan for $919,000, with a monthly payment of about $3,500.

Even though their loan won't reset for another two years, Campbell knows they're looking at a huge increase in monthly payments. If LIBOR was 1% or 2%, maybe they could make it.

If LIBOR exceeds 4%, there's no way they could afford the payments.

Let's say, for example, they added LIBOR at 4.5% to the 2.5% margin in their mortgage, the couple would see their interest rate jump to 7% and they would have to start repaying the principal. Their monthly payment would increase to $6,500.

"LIBOR is the fulcrum that bends us in a tough direction," says Campbell, an elementary-school teacher.

He tried refinancing to get a fixed rate but gave up after mortgage brokers told him he'd need to put up $200,000 to get a 6.5% rate. Other banks quoted rates that, he says, would have doubled his monthly loan payment. Campbell says he was surprised, because he and his wife have good credit and pay their bills on time.

Prime borrowers with smaller mortgages should have an easier time refinancing, mortgage brokers say. And they are advising borrowers who have ARMs tied to LIBOR to do so now.

Keith Gumbinger, a vice president at HSH Associates, a financial industry publisher, said prime borrowers with good credit should be able to secure a 30-year, fixed-rate mortgage in the low 6% range. (You can search our extensive database for the best mortgage rates in your area.)

That may be more than what borrowers are paying now, he says. But it's still a better proposition than riding the LIBOR roller coaster, he adds.

He and other brokers say subprime borrowers will have a much harder time refinancing. They recommend that these borrowers explore refinancing through Federal Housing Administration programs.

Another option is to contact lenders and tell them you're having difficulty making mortgage payments, says Guy Cecala, CEO and publisher of Inside Mortgage Finance Publications. They may lower your loan.

"There's a huge amount of pressure on lenders by Congress and others to help borrowers who are facing LIBOR adjustments," he says. "Your chances are better than ever of getting some sort of relief."

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