The initial housing boom began in early 2002 - 2003. Interest rates were falling to all-time lows. A surge of homebuyers eager to take advantage of the low interest rates on mortgages began pushing home prices up. As home prices climbed, buyers began turning from fixed-rate mortgages (where the interest rate charged on the loan does not change) to adjustable-rate mortgages or ARMs (where the interest rate does fluctuate over the life of the loan, within certain limits, in response to market conditions).

Many buyers liked that ARMs usually offer a lower initial interest rate than fixed-rate mortgages and reasoned that the low interest rates would continue for the foreseeable future. With a lower interest rate many buyers felt comfortable taking on a larger mortgage loan, meaning buyers may have borrowed more money – whether that was just to afford a home whose value was rising more quickly than they had planned, or to buy a bigger, newer or simply more expensive home.

Home prices continued to rise, beyond what many homebuyers could afford. Buyers who could not qualify for a home loan increasingly turned to “subprime lenders.” These lenders make loans to borrowers with low credit scores. However subprime loans also come with higher interest rates, fees and prepayment penalties. Many subprime lenders offered “low doc” or “no doc” loans – meaning that buyers had to provide minimal if any paperwork at all to qualify for the loan. Many buyers used the opportunity to overstate their income in order to qualify for a larger loan.

As the demand for homes continued, home prices escalated beyond what many buyers felt they could afford. Lenders in both the subprime and the non-subprime, or conforming, mortgage markets began offering ARMs that allowed homebuyers to pay only the interest owed on the loan each month for the first couple of years of the life of the loan. These were called “interest-only” or IO ARMs. Another ARM - the option ARM - offered initial interest rates as low as 1% and the ability to choose your monthly mortgage payment amount.

In addition to new homebuyers, many existing homeowners opted to take advantage of the low interest rates and refinance their mortgages to take some cash out of the equity they had built up in their home – called a “cash-out refi.” Others chose to lower their monthly mortgage payments by refinancing from a fixed-rate mortgage to an interest-only mortgage or option ARM with lower initial interest rates.

The housing market eventually began cooling off in most places as interest rates began to slowly rise. As interest rates crept up the interest rate on ARMs began adjusting upward, meaning people holding ARMs were now facing increasing monthly mortgage payments. Let’s take a closer look at what happens to homeowners holding IO or option ARMs when interest rates rise:

• Interest-only ARMs. With IO ARMs, homebuyers were able to pay only the interest on their home loan each month for the first several years of their loan. Because their initial monthly payment was lower than with a fixed-rate mortgage (because they didn’t have to pay any of the principal due on the loan), homebuyers often bought a more expensive home than originally planned – either because they wanted a more expensive home or because the price on the home they wanted to buy had risen.

Some homeowners chose an IO loan because they either already had a higher interest-rate home equity line of credit (HELOC) or needed a second mortgage to qualify for the home they wished to purchase. They could then use the money freed up from making lower monthly mortgage payments with an IO loan to pay down the second mortgage or HELOC.

When interest rates rise the monthly mortgage amount rises. In many cases homeowners who chose an IO loan were only able to truly afford the home if they were repaying the initial low interest rate they got. As that rate rose they found it harder to make the payments. In addition many IO loans had prepayment and refinancing penalties so many homeowners who wanted to switch to a fixed-rate loan were unable to come up with the money necessary to do so. Even if they could find the money to pay the penalty in some cases as the housing market cooled and home values began dropping, or readjusting, they found their homes were not appraising for as much as they thought. In some cases the homes were actually valued for less than when they purchased it. The home’s appraised value is important because it’s what real estate professionals use to establish a sale price and it’s a key component of how lenders determine how much money they would be willing to loan someone if they were using the home’s equity as the collateral for the loan. For example if someone wanted to take out a home equity loan – to make renovations to the home, pay off credit card bills, pay for college tuition, etc. – the lender would check to see how much the home is valued for before deciding if and how much they would be willing to lend the homeowner. If your home’s value has not increased, and especially if it’s decreased to the point that you paid more for the home than it is now worth, the lender is not as likely to make you a loan.

• Option ARMs. Many homeowners that purchased their homes using these loans either were not made aware of, or did not understand, all the specific details of the loan before signing the papers.

Many borrowers found the very low interest rates offered with an option ARM – some as low as 1% - very attractive. In addition borrowers could choose how large a monthly mortgage payment they wanted to make. However the interest rate on an option ARM adjusts monthly. So a loan with an initial interest rate of just 1% could jump several percentage points higher just 30 days after the loan papers were signed.

Homeowners may not have even realized they were getting a rate hike because the monthly mortgage payment amount only adjusts annually. So one year after choosing an option ARM, borrowers who chose to make the minimum monthly payment (more than 80% of all option ARM borrowers, according to Fitch Ratings) discovered that a higher interest rate boosted their monthly mortgage payment. In some cases they discovered that what they had been paying did not even cover the interest charged on the loan. So although they were making payments each month the actual balance on the loan was increasing, not decreasing. Over time their home was costing them more money. As interest rates increase fewer people are interested in buying a home and taking on a mortgage (especially if they think there’s a chance the rates could decrease again) and so with less demand, housing prices began to stabilize. In many areas where housing prices rose quickly prices not only stabilized but began to decline. And so homeowners holding an option ARM in those markets were in some case paying money for a home that was losing value.

In addition, with an option ARM every 5 or 10 years the monthly mortgage payment amount must be adjusted so that the loan can be fully paid off through the remaining monthly payments – that’s called a fully-amortizing loan. Lenders can raise the monthly mortgage payment amount by whatever amount is necessary (above the original 7.5% increase limit to make the loan fully-amortizing). And if the homeowner has not been paying enough to cover the interest on the loan and the loan balance rises to between 110% - 125% of the home’s value (meaning that the homeowner owes between 10 and 25% more on the loan than the home is worth) then lenders can immediately raise the monthly mortgage payment to make the loan fully-amortizing.

What Could the Current Mortgage Crunch Mean for You?
There are several potential consequences you may be facing now, or may find yourself facing in the near future and some steps you can take to minimize the effect of a tighter mortgage market:

• You may find your mortgage payments increasing to significantly more than you expected or beyond what you are able to pay. If you took out an ARM most likely the interest rate on your loan has risen. That means you now have higher monthly mortgage payments. If you took out an IO or option ARM you may not have been aware of some of the details and potential financial risks of these loans. Or you may have ignored or failed to appreciate the risks because, like many people, you thought interest rates would remain low, and that your home value would steadily rise along with your ability to pay down the loan.

Read our “What to Do When it Becomes Difficult to Pay Your Mortgage” article to learn what options may be available to you and/or what possible steps you could take to keep current on your mortgage and avoid foreclosure. Work closely with your lender and look into local credit counseling or housing agency resources to determine if and how you could remain in your home and remain current on your mortgage.

• You may find it more difficult and more expensive to buy a home. Lenders are going to make fewer home loans and will not offer as many mortgage options as in the past. The loans that they do make are most likely going to require higher credit scores than in the past, larger down payments and more documentation to prove that you can afford the loan.

If you are thinking about, or planning to buy a home here are a few things to consider doing:

Get and review a copy of your credit report. If there are any errors that may negatively affect your credit rating be sure to correct them. If you have a low credit score work on improving that first by paying bills on time and in full (when possible), paying down debt as quickly as possible and closing out as many open lines of credit or credit cards as possible.

Accumulate as much of a down payment as possible. Lenders are beginning to require a larger down payment as proof of your commitment to maintain and repay the mortgage.

Compare several loan options from different lenders and make sure you clearly understand the terms of the loans you are considering.

Talk with a lender about government-backed home loans in addition to conforming (non-subprime) loans. These are typically low down payment loans primarily for first-time homebuyers. If you qualify for an FHA loan from the Federal Housing Administration or a VA loan from the Veterans Administration you may have an easier time obtaining a mortgage.

Work with a real estate professional to ensure that you know what home values are in the area where you’re considering purchasing a home.

Read our Home Buying 101 section to learn more about wise steps to take when purchasing a home.

• You may find it more difficult to sell your current home. Rising interest rates and declining home values are making it tough to sell a home in some markets. Homes are staying on the market longer, going for less money, and sellers are paying closing costs and kicking in other benefits to entice buyers.

If you are thinking about, or planning to sell a home here are a few things to do and consider:

Work with a real estate professional to get comparables – prices that other, comparable homes have sold for in your area – to know realistically how much you can expect to price your home for, how long it may stay on the market before selling, and what renovations or upgrades you may want to consider making in order to attract a buyer.

Talk with a real estate professional about what types of concessions you would be willing to make to attract a buyer. For example, would you be willing to help pay all or a portion of the buyer’s closing costs? Would you be willing to include items the buyer might be interested in such as curtains, drapes, outdoor deck furniture, etc. that is currently in the home or on the property? Could you be flexible on the move-in date and accept an earlier, or later, date than you had originally anticipated?

If you are selling this home in order to buy another home be sure to include a contingency clause in your contract. A contingency clause states that your commitment to buy a home is contingent – dependent on – you first selling your home. Without that clause you can legally be held to the contract and made to purchase the home even if your home does not sell.

Read our Homebuying 101: Selling a Home section for more tips on selling your property.

• You may find it more difficult to get a second loan or mortgage to renovate your current home or finance other obligations. If you are a homeowner, lenders may be reluctant to make an additional loan or second mortgage even if it’s to make needed renovations to your home. They may not want to see you take on additional debt even if you feel confident that you can repay the additional loan.

If you are thinking about, or planning to apply for additional financing:

Review your credit report. Make sure you know your credit rating and fix any errors on your report if there are any.

Reconsider your need for financing. Why do you need additional financing? Is it a project that you need to undertake immediately? Do you need funds to pay your bills? Consider working with creditors, freeing up funds from other places in your budget or postponing projects until a time when it might be easier to obtain financing.

If you absolutely think you must get additional financing, consider alternate sources of funding. If you do need funds look for other alternative means rather than applying for a second mortgage. Do you have savings you could tap into or investments that you could liquidate (use) without having to pay a penalty? Could you make some changes in your budget and spending habits to free up some money or take on additional work? Think through all of your options before applying for a loan.

• You may find it more difficult and/or more expensive to refinance your home loan. Refinancing a loan means getting a new home loan (usually at a lower interest rate) to pay off your existing/old home loan. Many homeowners are finding it difficult to refinance because property values are declining. In fact values may be less than the original price they paid for the home - a situation known as being “upside down.” Your home’s appraised value is an important component of a lenders’ decision whether or not to allow you to refinance a loan. If you owe more on your home than it is actually worth a lender will probably see that as a risky loan to make and is probably unlikely to make the loan. Because a mortgage crunch and tightening credit market affects lenders’ abilities to borrow money (which they then in turn loan to consumers such as yourself), you may find it difficult to refinance a loan even if you have good credit and your home’s appraised value has remained stable.

In addition, your original loan may have steep prepayment or refinancing penalties. That means that if you were allowed to refinance the loan you would need to pay possibly thousands of dollars out of pocket to do so.

Read our Homebuying 101: Refinancing section to learn more about refinancing and questions to ask yourself and a loan officer before applying to refinance your current loan.

In a market where credit is tightening it will very likely take more patience, more money, more flexibility and better credit scores to buy or sell a home. It’s worth investing the time to educate yourself about how the market is changing and how that may affect your housing needs. If you are in a critical situation with your current mortgage use our What to Do When It Becomes Difficult to Pay Your Mortgage section to do everything you can to best work with your lender, and local credit counseling agency (affiliated either with the Association of Independent Consumer Credit Counseling Agencies or the National Foundation for Credit Counseling) or a U.S. Department of Housing and Urban Development (HUD) housing counseling agency to resolve your situation and make the best possible financial choice for yourself and your family.