An option ARM is like subtraction soup, except that a steady diet of minimum payments can result in a feeling of homelessness instead of hunger. To pile on the alarming rhetoric, a recent cover story in BusinessWeek dubbed the option ARMs "nightmare mortgages" and called them "toxic" and "deceptive."
Payment option adjustable-rate mortgages are appropriate for some borrowers in certain circumstances, and they're dangerous for other people.
Assessing your risk
If you have an option ARM, there are ways to assess your risk and steps to take. Here are some risk factors to watch for:
5 risk factors
1. You don't understand how an option ARM works, but you have one anyway.
2. You exaggerated your income on your application.
3. You regularly have been making minimum payments.
4. You're approaching the principal cap.
5. House prices in your neighborhood are falling.
1. You don't understand how an option ARM works, but you have one anyway.
Mitch Ohlbaum, president of Legend Mortgage in Los Angeles, bemusedly pages through the BusinessWeek article that calls option ARMs nightmare mortgages.
"They're nightmares to the extent that people don't have them explained," Ohlbaum says. "I get calls all the time from people who say, 'I took this loan, I didn't understand it, my rate keeps going up. No one explained it to me."
Option ARMs are hard to describe. Mortgages lie on a spectrum from the fairly simple to the sublimely complex, like the math taught from first grade through college. Fixed-rate loans are like basic arithmetic. Adjustable-rate mortgages are like algebra. Option ARMs are like calculus. Plenty of homeowners are furrowing their brows in calculus class when they should be memorizing their multiplication tables.
An option ARM is an adjustable-rate mortgage that gives the borrower four choices of a payment each month. The borrower can pay the amount necessary to pay the loan off in 15 years or in 30 years. The borrower can pay only the interest charged in the previous month. Or the borrower can make a minimum payment that doesn't even cover the interest, so that the loan balance increases.
Most option ARMs have absurdly low introductory rates, sometimes below 2 percent, that last just a month. Then they rise. And rise. The rate changes each month, but the minimum required monthly payment changes only once a year.
"The thing no one realizes is the rate is fixed for only 30 days," Ohlbaum says. "The payment is fixed, and that's nice -- but the rate isn't."
As the introductory interest rate doubles, then triples, then quadruples and even quintuples, the minimum payment rises a maximum of 7.5 percent a year. Some borrowers may find that, when they make the minimum payment, their loan balance increases more than $1,000 each month.
Most option ARMs are indexed to the average yield on one-year Treasuries in the past year -- an index known as the one-year MTA. That average has been rising steadily and will continue to rise. The rate on the loan is calculated by adding the one-year Treasury average to a margin that varies from loan to loan.
For an example of how this works, look at the one-year MTA on Bankrate's summary of Treasury securities. On Sept. 6, the one-year MTA was 4.664 percent. If your margin is 3 percentage points, your rate equals the index plus the margin: in this case, 7.664 percent. One month before, the fully indexed rate was 7.563 percent, and a year before it was 5.64 percent.
If you got an option ARM without understanding these basics, it's time to learn. The main thing you need to know is this: Since the one-year MTA is based on average one-year Treasury yields for the past year, and one-year Treasury yields have been rising in the past year, it is sure to keep rising into late winter and probably longer.
2. You exaggerated your income on your application.
A lot of option-ARM borrowers have stated-income loans, in which the lender doesn't verify the amount that the borrower claims to earn. For auditing and fraud-fighting purposes, borrowers sign a document that allows the lender to do a spot-check with the Internal Revenue Service.
In July, National Mortgage News reported that an unidentified lender took a random sample of 100 stated-income loans, looked at the borrowers' tax returns and discovered that 90 of the borrowers had lied. Thirty exaggerated their incomes by between 5 percent and 49 percent, and 60 borrowers had puffed up their incomes by 50 percent or more. Just 10 told the truth. The lender didn't say how many of these stated-income loans were option ARMs.
Bottom line: If you lied about your income, you're more likely to find that you don't earn enough to pay your debts.
3. You regularly have been making minimum payments.
If you have been making minimum payments most months, you're not paying down your debt and might, in fact, be increasing it. You feel this not only in your pocketbook, but in your gut.
"It's a monthly toll," says Bob Moulton, president of Americana Mortgage, a brokerage on Long Island, N.Y. He sees option-ARM borrowers fretting over the monthly rate increases and wondering where it will lead.
"I mean, they're angsting over this change happening each month. This is what I'm seeing," Moulton says. "The worst is if you have that and the home equity (loan) on top of that. You see that going up every month and you're dying."
4. You're approaching the principal cap.
When you make the minimum payment, and the loan balance increases, that phenomenon is called "negative amortization."
Lenders won't let negative amortization go on forever. They set principal caps -- limits on how far negative amortization can go. Most option ARMs have a principal cap of 110 percent, meaning that if your loan balance reaches 110 percent of the initial loan amount, you'll suddenly have to start paying down the loan balance.
Before you reach the principal cap, the minimum monthly payment can rise only a maximum of 7.5 percent a year. After you reach the principal cap, that limitation is thrown out the window. The minimum monthly payment can more than double in some cases.
The monthly billing statement should tell you the current balance. The promissory note will spell out the initial loan amount.
5. House prices in your neighborhood are falling.
The danger with falling houses prices is that your home's market value could fall below the amount you owe on it. That puts you in a position where you can't afford to refinance the mortgage or sell the house unless you have enough cash lying around to make up the difference. And if you have that much cash, why are you in over your head with your mortgage?
"Basically, what you're going to have on a lot of those pay option ARMs is you're going to see a lot of customers giving the keys back," says Mark Lefanowicz, president of E-Loan.
Lefanowicz says E-Loan has underwritten 60 or 70 option ARMs in the past year, a small number that reflects that "it's just not the right option for a lot of people."
What to do if you have an option ARM
Lots of people are fine candidates for option ARMs. The loans are well-suited for people whose incomes vary from month to month (think small-business owners and salespeople on commission) and people who get a big chunk of their income via bonuses (your boss's boss's boss, investment bankers and sundry corporate chieftains).
Ohlbaum says he has a client who gets half his income from an annual bonus. He pays the minimum amount most of the year, and then pays back all the negative amortization with one huge payment. "It makes perfect sense for the right guy, and he's the right guy," Ohlbaum says. And if you're like that guy, an option ARM probably won't hurt you.
On the other hand, "most regular people who have a regular-paying job do not belong in a loan like that," Ohlbaum says. "They're going to get in trouble."
To stay out of trouble, there are a number of things you can do if you have an option ARM: Make at least the interest-only payment, refinance the loan or sell the house and pay off the mortgage.
By making the interest-only payment, you're at least treading water instead of sinking under the waves. You're not paying down principal but you're not adding to it, either. As rates rise, the interest-only payment rises.
"If you got this loan a year ago and you can make the payments the next couple of years, just keep an eye on it," Lefanowicz says. "Don't panic."
Time for plan B?
But if you can't handle interest-only payments, it's time for plan B.
Plan B is refinancing the loan. If your current lender did a lousy job of explaining an option ARM, you'll probably want to avoid refinancing with that lender. "My best advice you can do is go to someone like us," E-Loan's Lefanowicz says. "Our loan consultants don't get paid more for giving the customer a higher rate."
You will want to talk to your current loan servicer to find out if there's a prepayment penalty and how much it would cost. Most option ARMs have prepayment penalties, which you are charged if you refinance the loan or sell the house within a specified period, usually one to three years.
Ohlbaum has a client who wants to refinance his $450,000 option ARM. It has a 2 percent prepayment penalty, which means the borrower has to shell out $9,000 just to refinance. But the rate on the option ARM is 1.25 percent higher than what he could get on a 30-year fixed, and he will be able to save about $450 a month by refinancing. He will break even in about 20 months.
"You kind of have to go, 'OK, I made a mistake. Let me get out sooner rather than later,'" Ohlbaum says.
Or maybe plan C?
Then there's plan C: selling the house and paying off the loan. The main reason to do this is that you've looked at your finances and you realize that you bought too much house. You just can't afford your house and achieve your other financial goals at the same time. In other words, you live in California (only half-kidding).
You're an especially suitable candidate to sell the house and pay off the option ARM if house values are falling in your neighborhood. Unless you know that you can sit tight for five or six years while prices fall, stagnate and then rise, it's probably a good idea to test the real estate market. |
