Option ARM loans are about to bite their holders

Aggressive brokers sold home loans as inexpensive; rising rates will change that

In the past few years, the mortgage industry has been aggressively advertising on radio and television that they could provide borrowers with loans that might save them hundreds, or even thousands, of dollars per month over their existing loans. In some cases, they were promising loans at “half the price” of other mortgages. With these sorts of advertisements, borrowers flocked to loan companies and mortgage brokers to see what the promises were about.

The promises were about Option ARM loans, a mortgage created twenty five years ago to accommodate buyers who had irregular paychecks. If you are a salesman and get most of your income in a once-a-year bonus, it would be to your benefit to have a loan that would have low payments throughout the year but would allow you to make an annual lump payment to “settle up.” The Option ARM allows that, and for years was mostly offered to buyers with such needs. As interest rates and housing prices rose during the past two years, lenders and aggressive mortgage brokers began offering such loans to buyers, not for their flexibility, but for their low payments. 

There’s a problem with that, however. The low payments don’t stay low. After that, it gets worse.

The Option ARM loan works like this - the interest rate is flexible, but the monthly payments are initially set based upon an introductory, “teaser” interest rate. Buyers are given the option of paying one of four amounts each month:

• The “minimum” payment, based upon the teaser interest rate
• The payment of interest only
• The payment as though the loan were a 15 year mortgage
• The payment as though the loan were a 30 year mortgage

The minimum payment is artificially low; it doesn’t even cover the interest that has accrued during the month. By paying the minimum, and 80% of all Option ARM holders do, the amount you owe actually goes up. The longer you pay the minimum payment, the larger your debt becomes. Eventually, the debt becomes so large that the lender will be forced to increase the payments.

Apparently, a lot of the people who have these loans don’t know that, or they were talked into the loans by lenders or brokers based upon the affordability of the property based on the minimum payment. The minimum doesn’t pay for the property, though, and if the minimum is all you can afford, then you can’t afford the property. It doesn’t help that these loans are often accompanied by sky-high prepayment penalties, which make getting out of the loans rather difficult.

As rates continue to adjust and loan principals increase, tens of thousands of homeowners are going to find themselves facing a dilemma -Making payments they cannot afford or giving up the house to foreclosure. This isn’t an isolated case, in at least one state, some 50% of all loans issued during the past three years were Option ARMs. This problem is going to explode soon, and it won’t be pretty.