Why Option ARMs Are Scary

Posted by: Peter Coy on August 4, 2005

Option ARMs are scary because monthly payments can stay low for a long time and then suddenly go kerflooey. (Did I spell kerflooey right?)

Standard & Poor’s is out today with a press release about a report that explains why they tightened up their criteria for option ARMs, effective Aug 1. The report (which is available under Ratings Criteria on the S&P website, fifth item down) explains why S&P felt it necessary to assume higher foreclosure frequencies on option ARMs.

With an option ARM, you have the option to make a minimum payment that doesn't even cover all the interest you owe, let alone any of the principal. The unpaid interest gets added to the balance on the loan.

Annual caps on how much your payment can go up--typically 7.5%--give a false sense of security. The caps are like keeping your thumb over the mouth of a bottle while vigorously shaking it. Eventually, if you underpay what you owe for long enough, the principal on your loan will breach a preset limit, which tends to be either 10% or 25% greater than the original amount borrowed. At that point, all caps are blown off and the monthly payment jumps all the way up to whatever is required to fully amortize the loan over its remaining life.

Example given by S&P: The monthly payment goes up between month 48 and month 49 by 88%. On a $500,000 loan, using S&P's assumptions and my multiplying skills from fifth grade, that would be as follows:

Month 1: $1,665
Month 48: $2,070
Month 49: $3,900

"Payment shock" is what S&P calls this. Here's an understated quote from the S&P analysts:

... some of the borrowers may not have the financial wherewithal or the financial savvy to absorb or plan for sudden jumps in monthly payments.

Correct. Are mortgage brokers and lenders making the risks crystal-clear to all the people who are signing up for option ARMs because they're attracted by that low, low initial payment?

Reader Comments

Dr. Freeze

August 9, 2005 11:56 PM

Oh, yes...the wonderful "neg am" mortgages...their popularity is yet another sign that the end (of the bubble) is near...

katey

September 27, 2005 6:35 PM

help me!!! i got 2 sister in laws that's getting an option arm! i think it's too risky. they think it's ok because the payment for a $500,000 house is only $1200. what else can i tell them? i don't know too much about loans, but i do know math, and it just doesn't add up.

Mark

October 20, 2005 4:35 PM

Don't get to Freaked out what most so called financial experts forget to tell you is bad news sells. I have been doing loans for a long time and chances are statistically speaking most people don't keep the same loan for more than 3.8 years. If you look at his illustration above it shows fair stabiltiy until the 5th year. Secondly if you actually pay extra payments which by the way is why they call it an option arm. You actually pay down the principal much faster than if you had ia fixed higher rate in the first 5 years. People have to look at all scenarios and stop having stinking thinking. It's called tunnel vision that my 2$ worth. Rather we agree with it or not many people simply refinance or sell by the time the 88% increase would kick in

Mike

January 20, 2006 2:23 PM

I work for a bank, in the real estate loans division. We specialize in this type of product. It's important to understand that all option programs are not exactly the same. There are different recast periods, different indexes (very important), different margins, biweekly features, etc. All of these things effect the long term benefits of the loan. People are in just as bad financial trouble (retirement, ccard debt, etc.) as they are in trouble with the housing market. Cash flow created by these programs can help provide them with solutions to some of their other problems, which may be much more serious. It's something to think about.

Rich Bouchner

May 7, 2006 10:31 PM

As an owner of mortgage company, and ex buy side sales person on Wall Street, I view option arms like most other bank created products..there are upsides and downsides. Option arms are a powerful tool for a very specific type of client...ie: a client that derives a large portion of their income via bonus or commision, a client that has a short term time frame for holding on to the loan, or a client that can earn a higher rate of return on the free cash flow created by the option arm.
When option arms are sold to clients who are simply seeking to buy more house than they can afford...well that is when bad things happen.

Rich Bouchner
Principal
Commodore Mortgage Group

sami

September 3, 2006 10:50 PM

For the average client, these optional ARM mortgages are pure poison....most people have no idea what they are getting into. Those initial low payments look so good and are tempting. These loans do have a use--for the rich and investors who flip houses. Others who know the risks might use them if they expect a large increase in salary soon, an inheritance, etc. especially if they can afford to refinance if necessary (could be $15,000 or so to do it). Too many ordinary working people are finding out the risks too late....and many lose their homes if they can't sell.

Peter Coy

September 6, 2006 3:43 PM


People interested in discussing the "Nightmare Mortgages" story in BW should check out the guest post by the writer of the story, Mara Der Hovanesian, which was posted Sept. 6. It's called How Toxic Is Your Mortgage? Here's a link: http://www.businessweek.com/the_thread/hotproperty/archives/2006/09/how_toxic_is_yo.html

Cindy

October 24, 2006 9:36 PM

World Savings created this type of loan, thier agressive underwriting is the key to the make sense loan. Other lenders approve loans based on FICO score. Which in my opionion is not always the right way. Appraised value is key and World is very accurate with the value of properties. With a great borrower and a great property the slow moving index, higher min payment (which doesnt allow room for a lot of neg am) is the perfect match. A Great loan that a lot of borrowers including my friends and family are enjoying. You are right, you have to have the right option arm loan. Go to the lender that created it not duplicated it.

Georgia M DeMooy

August 1, 2007 5:06 PM

I went on this in the advice of my so called fiancial adviser. I am very disappointed in the arm rate. All I can say is no Senior shuld go on this and be on a fixed income

R. W. Dolan

January 4, 2008 1:19 PM

Rich, you are spot on!

Mark, I have done a lot of consulting for major mortgage players, and you make several misleading points. First, yes, the average life of a mortgage is short, but that is because most people refinance -- but many people with Option ARMs will not be able to do this after their principal grows, especially if affordability was the issue in the first place. Second, yes, you can make more than the minimum payment, but again this is difficult for people who chose this loan for affordability reasons -- about 2/3 of Option ARM borrowers make only the minimum payments. Also, it is misleading to say the curtailment/prepayment option is unique to this type of mortgage -- of course, you can make extra payments on any mortgage that does not have a prepayment penalty! Finally, I have no idea how you made the conclusion about how many people refinance these loans -- show me the stats, or I simply do not believe you due to my logic above.

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About

BusinessWeek editors Chris Palmeri, Prashant Gopal and Peter Coy chronicle the highs and lows of the housing and mortgage markets on their Hot Property blog. In print and online, the Hot Property team first wrote about the potential downside of lenders pushing riskier, "option ARM" mortgages and the rise in mortgage fraud back in 2005—well ahead of many other media outlets. In 2008, Hot Property bloggers finished #1 in a ranking of the world's top 100 "most powerful property people" by the British real estate website Global edge. Hot Property was named among the 25 most influential real estate blogs of 2007 by Inman News.

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