ARMs Control

That adjustable-rate mortgage seemed like such a great idea. Then interest rates started climbing.

The Federal Reserve raised rates again earlier this week, the latest in a string of 16 rate increases that have pushed the Fed’s overnight lending rate from 1 percent to 5 percent in two years. The Fed’s actions, combined with growing concerns about inflation, have helped push short-term and long-term rates up across the board.

Rising interest rates are generally bad news for borrowers. Those seeking to borrow fresh funds are forced to pay higher rates. Meanwhile, those who carry adjustable-rate mortgages and car loans find that the cost of past purchases rises sharply as rates float upward. Unfortunately, in recent years, American consumers and the American taxpayer—always prodigious borrowers—have lurched heavily into adjustable-rate financing. From 2000 to 2003, the surge in adjustable-rate financing and the culture of refinancing helped improve the financial standing of consumers and the federal government, but they are having precisely the opposite effect now. We’ve exposed ourselves to an unprecedented level of interest-rate risk. And it’s starting to bite.

The Federal Reserve’s May 2006 survey of consumer credit finds consumers paying higher rates on credit cards. Interest on revolving credit accounts (mostly credit cards) has risen from 12.73 percent in 2003 to 14.38 percent in the first quarter of 2005. That adds up to $13 billion per year in extra interest payments.

In real-estate, the adjustable-rate bomb could be even bigger. Home-buyers have increasingly turned to adjustable-rate mortgages (or ARMs) as prices have escalated. ARMs allow borrowers to lock in a lower rate in the short term in exchange for accepting the risk that they’ll pay more in the future if interest rates rise. With every passing month, however, as mortgage rates rise, more and more borrowers are stuck with higher monthly payments. According to the Office of Federal Housing Enterprise Oversight, the volume of ARMs tripled between 2001 and 2004, from $304 billion to $985 billion in 2004. At the end of 2004, there were about $1.4 trillion in ARMs outstanding. That figure is likely significantly higher today, since the ARMs accounted for about 31 percent of the $2.9 trillion in mortgages issued in 2005, according to the Mortgage Bankers Association. For every 100 basis points (i.e., 1 percent) mortgage rates rise, holders of adjustable of ARMs will owe an extra $14 billion per year in interest.

The U.S. government is also being punished by rising rates. The Treasury Department is constantly issuing new debt to pay down or replace older debt and to fund the budget deficit. Combine higher interest rates with higher amounts of debt, you get a sharply higher interest bill. According to the Bureau of the Public Debt, the average interest rate on the (mostly short-term) debt held by the public has risen from 4.019 percent to 4.642 percent in the last year—a 15 percent increase. As a result, as the latest Treasury Monthly Statement shows, the government paid $213 billion in interest during the first seven months of fiscal 2006, up from $185 billion during the same period in 2005. The total interest tab for fiscal 2006 is projected to be $399 billion, up 14 percent from about $350 billion last year.

In the scheme of a $2.7 trillion budget and an $8.4 trillion national debt, an extra $49 billion in interest costs may seem a trifle. But the extra money spent on interest doesn’t provide benefits to anyone save investors, many of them foreign. In today’s increasingly constrained Washington, where an argument over an extra $15 billion in spending may lead President Bush to use the veto for the first time in his presidency, these numbers matter. And in the economy at large, with wages lagging inflation, every penny of extra interest consumers pay is one less penny available to spend at Wal-Mart or Costco. High interest rates can make everybody—even the most free-spending among us—feel a little less generous and a little more pinched.