Option ARMS: How they work and just how ugly they can get.

NEW -> Contingent Buyer Assistance Program
<p><em>The truth in lending disclosure will show you 31 months, or 28 months, or 41 months etc....</em> </p>

<p>You lost me, you mean they showed the projected recast based on using the minimum payment tripping the LTV cap?</p>

<p>The minimum really is fixed for 5 or 7 years as long as you don't use it regularly, correct?</p>
 
<p>correct!</p>

<p>graphix, part of may daily routine is indulging in a little schadefreude. I can't tell you how many people I try to refinance and pay the prepayment penalty. It's tax deductible because it's technically an interest charge. These people were just hoping the equity appreciation would bail them out.</p>

<p>From what I've experienced, 90% or more of the people in neg am loans make the minimum, but do you know what is more scary? I'd say at least 1 in 3 people I talk to (33%) who have this loan can ONLY make the minimum payment! This means that they have no chance of refinancing, even if they have equity, and rates are low. </p>
 
<em>I'd say at least 1 in 3 people I talk to (33%) who have this loan can ONLY make the minimum payment! This means that they have no chance of refinancing, even if they have equity, and rates are low.





</em>Not surprised in the least bit....if they could make more than the minimum payment they would have refi'd into a fixed rate...a year or so ago.





Heads will roll....c'est la vie
 
<p>NSR - This loan came in many different terms. The one I wrote about is where the minimum payment is fixed at 1% for a year and adjusts every year after. There is a version where the minimum is fixed for 5 years but at a higher rate like 2.25%. The underlying rate though will be higher at over 8%. You can thank Bear Stearns for this bad boy.</p>

<p>The TIL - Truth in Lending disclosure is a disclosure that the borrower signs at the time of application and again at the close. The TIL will spell out the terms and uses the current underlying rate. If the underlying rate is high enough and the minimum is low enough the loan will reach 110% of the balance before the 5 years are up and it will recast to a fully amortized payment at the current rate. The TIL will show this happening, what month it will happen and what the possible payment would be using the rate at that time which is the index plus the margin. I have a story about this that I will share later.</p>
 
<p>The rate on these programs is adjustable every month, and every month for the last three years rates have been increasing. The TIL is not a fortune teller and cannot predict what future rates are. This means that the TIL estimated the recast point based upon the interest rate at the time of signing. As interest rates rose, that recast date shortened, because the borrower was deferring more and more interest each month!</p>

<p>Yikes!</p>
 
<p>Its unfortunate that this loan is being demonized to the level that it is. </p>

<p>It is not satan's spawn, it is a financial tool that if utilized properly can be a valuable mortgage for many people. The problem arises when people abuse the loan and use it for the sole purpose of qualifying people for a more expensive home or a home that they should never have bought in the first place.</p>

<p>Although the MTA index is highly volatile, the option arm can be based on more stable indexes such as the CODI COSI or COFI indexes.</p>

<p>It is a mortgage that was abused and misrepresented by brokers, banks and borrowers, and now they will all pay the price.</p>
 
<p>This type of loan has not made sense at all in my opinion, and here is why. The only reason you would even consider doing this would be if you could invest your money into an account that yielded a higher rate than your mortgage note. Most of these fully amortized rates are over 8% now. </p>

<p>The loan was never a financially sound tool to use. Broker's would say.."Instead of paying the interest on the mortgage, invest it and make your money work for you." I'm sorry but there hasn't been a stable investment in the last 6 years that would yield a rate of return greater than the rate on the mortgage. If that's the case, why would investors buy MBS bonds? Sure you could put it in the stock market I suppose, but by not locking in a low 30 year fixed rate, you are offsetting your gains by having to assume a higher rate on your debt in the future.</p>

<p>The loans were being offered because it allowed people to finance more debt. Period. Using it as an investment tool is foolish. Just do an interest only loan that's fixed for 7-10 years if you want to be a little more risky. Deferring interest on a loan that adjusts every month is insane if you stop and think about it.</p>
 
<p><em>If the underlying rate is high enough and the minimum is low enough the loan will reach 110% of the balance before the 5 years are up and it will recast to a fully amortized payment at the current rate.</em> </p>

<p>Yes, that's the way I understood the loans worked. I was unaware though that the lenders actually put the early recast by the LTV reset in the TIL.</p>

<p>IMHO, if the TIL is telling you it only lasts 29 months, which many would, people don't have much of an excuse other than they didn't read it. I wonder though, if part of the TIL lawsuits are because the TIL says something like 31 months and due to the interest rates rising, actually forced LTV recast to occur earlier. </p>

<p>I'm with IR on this one, I can't believe they sold these to general population. Er, okay, I am not, profit afterall. They're a lot like guns, guns don't kill people, people do. If you leave your gun unsecured you can be held liable, the lending industry basically loaded it, set it on the coffee table walked out the room leaving the toddlers behind watching cartoons. Yes, I know, people are adults and need to be responsible, but in an industry with so many advisors, it's pretty pathetic that it occured and the whole gamut is responsible IMHO, from the buyer, to the agents, to the brokers, appraisers, banks, on down the line including Moody's for ever putting a AAA stamp on those convoluted messes of CDOs and the pension funds like CalPers for buying them.</p>
 
<em>"It is not satan's spawn, it is a financial tool that if utilized properly can be a valuable mortgage for many people."</em>





I don't agree -- at least with the word "many." I think there might be 2 people in 100 with the sophistication and self discipline to handle this loan. Everyone likes to believe they are in that 2%, but they aren't. I doubt I could handle the temptation of this loan. When people are given multiple payment options for the same product, they will always chose to spend the least amount. It is basic human nature. The discipline required to make the larger payment when faced with the inevitable needs and wants of existence is just too great.





For example, lets say you have an unexpected car repair. Do you give up your weekend trip to Vegas because you can't afford it due to the unexpected expense, or do you make the minimum payment that month and go on your trip? Lets say you don't have as much saved as you would like for spending on Christmas presents for your kids. Do you act like Scrooge, or do you have a nice Christmas and make the minimum payment that month.





As you can see, something will come up every month, and before you know it, you are one of the 98% who cannot handle this loan.
 
<p>Actually, it's kind of sad that as a nation, we modified credit cards so that the credit cards companies where forced to at least make the minimum payment cover the accrued interest a provide a timely (decades long) payoff for revolving debt to prevent people from entering a death spiral of debt.</p>

<p>While congress was busy being lobbied and reaching that minimum control over the debt providers, they basically turned people's homes into a giant old fashioned credit that didn't have the minimum payment covering interest requirement.</p>

<p> </p>
 
IR - I am 1 of the 2. Our last home had an ARM and the lender changed it to an option ARM while we were making payments. It scared me so much, we started making extra principal payments with every monthly payment. True story.
 
I think the problem with this loan is not the loan itself but the lack of risk assesstment on pricing and qualifing standards. When I first learned about this loan to qualify for it alone was difficult but not only that but the way rates were determined made it so that it would be nearly impossible to recast. The minimum payment would not only cover the interest but some principle as well. It is a great loan in a high interest rate enviroment because as the rate drops the more principle gets paid. It is when the the lenders lost all sense of reality by lowering the qualification standards and didn't bother to think that rates might return to normal that screwed this loan up.
 
<p>I saw an ad in the OC Register for a loan from a Credit Union this morning for a 5 Year ARM that reset once every five years for the five year payment with a reset cap of 2% or their current rate, whichever is lower. Current rate was listed as 5.625% (9/1) Ah, here's a link. https://www.penfed.org/productsAndRates/mortgages/firstMortgageLoans55ARM.asp</p>

<p>Is this a new modification or has it been around a while? Without seeing the fine print having a rolling 5 year ARM seems like a decent tool to use on the surface. The ability to project and be certain you can handle the next 5 years at 7.625% max is much easier than a regular ARM reseting every 6 months or year.</p>

<p> </p>
 
Tanta at Calculated Risk is a genius. Anyone struggling to understand Option ARMs should read this piece.





<a href="http://calculatedrisk.blogspot.com/2007/09/clockwork-mortgage.html" linkindex="361" set="yes">A Clockwork Mortgage</a>
 
When the third sentence in the second paragraph is <em>"It has to be more fun than a sharp stick in the eye." </em>You know that it is going to be a classic Tanta rant. That and any time "jingle-mail" is mentioned I have to laugh.
 
<p>Interesting.......</p>

<p>I agree that these are now and have been bad loans in the past 4 years, BUT</p>

<p>I got into an Option Arm in 2002. It was through a broker, but the loan was thru Wamu. As you know, I had the option to make the Min payment, Int only, or 15yr p&I, or full 30yr p&i. I ALWAYS made the min payment. From 2002 to mid 2004, I made the <u>min fixed payment</u> and guess what, my principal was being paid AS WELL!!!! MY BALANCE WAS GOIING <u>DOWN</u>. This was because of the falling interest rates. When my payment began to rise (quite rapidly in late 2005) I refinanced to a 5.5% 30 yr fx with 10 yr int only option. </p>

<p>But this is an example how this loan program was great, and how <u>smart</u> people took advantage of it at the right time. My rate for 2 years was in the 3%-4% range. I understood it from the beginning, and I took a gamble at it and it surely paid off.</p>

<p> </p>
 
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