Option ARM Borrowers Running Out of Time

Huge numbers of option ARMs will likely fail in the next 24 to 30 months

By Peter G. Miller, RealtyTrac | Published: 11/18/2008

Step right up folks. You say you want to buy a home but have no money. You say monthly payments are unaffordable but you want to buy anyway. Well don't worry about a thing. You've got a friend in the business. Let me introduce you to the option ARM, an affordability mortgage product that can get you into the home of your dreams.

Of all the mortgage ideas developed during the past few years, none tops the option ARM for sheer awfulness. And now the mortgage mess is about to get far worse as millions of option ARMs begin to recast. Not "reset," but recast.

Fitch Ratings says in a report that option ARMs worth $200 billion are now outstanding. Among these loans, Fitch expects roughly $29 billion to recast by the end of 2009 and an additional $67 billion to recast in 2010; that's almost half of all the option loans now held by lenders.

The problem is what happens when required monthly payments change. According to Fitch "the potential average payment increase on this recasting population is 63 percent, representing on average an additional $1,053 due each month on top of the current average payment of $1,672."

You don't have to be a math major to figure out what will happen next: Huge numbers of option ARMs will fail in the next 24 to 30 months with results that will be devastating to borrowers, loan portfolios and local home values.

Formally known as "payment option adjustable rate mortgages," option ARMs are the most complex residential loan products ever offered. In brief terms, they work like this:

A borrower wants a $500,000 mortgage and gets an option ARM. Each month for the first five years of the loan the borrower can make one of four payment choices each month:

• Pay the loan on a 30-year self-amortizing basis just like a traditional mortgage. The monthly cost for principal and interest at 6.5 percent would be $3,160. Taxes and insurance are extra.
• Pay the loan on a 15-year self-amortizing basis. While the mortgage would be repaid in half the time when compared with a 30-year loan, the monthly cost for principal and interest would rise to $4,356.
• Rather than amortizing the loan -- reducing the debt with each payment -- option ARMs allow borrowers to make interest-only payments during the start period. At 6.5 percent, the interest-only monthly payment falls to $2,708.

• Lastly, we have the real attraction of option ARMs, the option payment itself, a payment which is insufficient to even pay off the monthly interest cost. How much? About $1,325 a month when calculated on a 40-year basis. Huh? Why look at 40 years and not 30? Because Fitch says that a 40-year loan term represented 4 percent of all option ARMs in 2004 -- but 38 percent by 2007.

A loan with four payment options may seem fairly understandable, but in the real world a lot of borrowers did not take out option ARMs because they wanted to make fully amortizing payments. They took out such loans because they could borrow $500,000 at $1,325 a month instead of $3,160. The ability to afford a bigger mortgage also meant the ability to buy a bigger and better house. For option ARMs originated in 2006 and 2007 LoanPerformance says that 85 percent of all borrowers are paying no more than the minimum monthly payment (MMP), according to Fitch.

Not only are option ARMs highly affordable in terms of initial monthly payments, lenders made such loans enormously attractive. For instance, to reduce down payment requirements borrowers could buy with "piggyback" financing, deals with a first loan equal to 80 percent of the purchase price and a second loan equal to 10 percent, 15 percent and even 20 percent of the sale value. In other words, with an option-ARM and piggyback financing you could buy a home with little or nothing down and sharply discounted monthly costs.

And that's not all. You could get your option ARM or your piggyback deal with a stated-income loan application, an application where you estimated your monthly income and the lender generally did not check your figures. A report by Credit Suisse showed that 49 percent of all ALT-A mortgages -- the loan category that includes option ARMs -- were made with stated income loan applications.

"Option ARMs only provide borrowers with these payment options for a finite timeframe," explained Credit Suisse in its 2007 study, "which sets the stage for a significant payment shock when payments are recast to the fully amortizing rate at the current interest rate level. Depending on the amount and terms of the loan, monthly payments could increase in excess of 40% upon rate reset on these types of mortgages."

But, as they say on late night television, there's more.

NEXT: Resetting versus recasting