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The Long “Option ARMs” of the Loan

When the housing market was going strong between 2004 and 2006, many buyers were purchasing houses they were not able to afford with conventional financing. That created a need for less conventional mortgage products known as option ARMs (adjustable rate mortgages). These mortgages allowed a buyer to either pay less of an interest rate during the first few years of the loan or in some cases to pay ONLY the interest for a period of time.

How did these mortgages work? The best explanation I have seen comes from Mortgage News Daily:

These mortgages have “flexible” payment options, allowing the borrower to make a minimum payment (usually as low as 1%) or an interest only payment and to choose whether to amortize the loan mortgage over 30 years or 15 years. Basically, what happens when a borrower elects to pay the minimum payment is that the borrower is paying less than the actual rate of interest on the loan, deferring a portion of the interest owed. The deferred portion is added to the balance of the loan, causing the overall size of the loan to grow because no principal is being paid down either. The interest grows until a limit is reached – usually 110 to 125% of the original loan balance. When the limit is reached, the borrower is no longer permitted to make the 1% minimum payment and the loan recasts itself with a new monthly payment that is usually much higher than the initial 1% payment. These loans usually recast themselves every five years.

Why would a borrower agree to this? It enabled them to buy a higher priced home while paying a lower mortgage payment. The thinking was that the home would continue to appreciate over the first few years thus allowing the purchaser to refinance to a more conventional loan at a time in the future when they could afford normal payments thus avoiding the recast and the much higher payment.

However, what actually happened was that, in most parts of the country, the house not only didn’t appreciate, but instead lost value from the 2004-2006 price. In many cases this eliminated any chance of refinancing.  That left the homeowner to deal with the higher payment at the time of the recast. How much higher? In an article at CNBC.com on January 12 they detailed possible scenerios:

Some 88 percent of Option ARMs originated between 2004 and 2007 are going to adjust higher between now and 2012. Those option ARM borrowers could see their housing bills go up as much as 63 percent, according to Fitch ratings.

Obviously, in a struggling economy an increase in the mortgage amount could cripple families. And that is exactly what is about to happen.

Below is  a graph from Amherst Securities showing the number of loans about to be recasted in the next two years.

What does this all mean? That, at a time of tremendous financial hardship, many families’ mortgage payments are about to increase. In some cases, rather dramatically.

End result? I don’t believe we truly have a handle on how many foreclosures will hit the market over the next 12 months.


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3 replies
  1. Michael Mekler
    Michael Mekler says:

    Steve,
    I love your post. The subject of the option arm is one that has been beaten lately almost daily. The statement above:
    “Some 88 percent of Option ARMs originated between 2004 and 2007 are going to adjust higher between now and 2012. Those option ARM borrowers could see their housing bills go up as much as 63 percent, according to Fitch ratings” Is not entirely accurate. As someone that lives in the center of the option arms, San Diego, we know that the recast of these loans will happen when 1 of the first 2 scenarios occur:
    1) The initial 5 years have gone by
    2) The new loan balance has reached 115% of the original loan amount

    If we do the math on a $400,000 loan, the recasting of the majority of these loans has already happened because they have reached the 115% just after 28 months of making the minimum payment. The higher the loan amount the shorter the recast period. Since the last of these loans were originated in late 2006 the above graph, in my opinion, is a non-issue.
    In addition, Bank of the West(World Savings), Downey Savings, Indimac and Countrywide(Bank of America now) gave huge incentives to the lending community to refinance these loans.

    Reply
    • Steve Harney
      Steve Harney says:

      Michael,
      Great points. I understand what you are saying. In this blog, I speak on what data is being reported so people can more easily understand the housing market at the current time. I used a recently released Amherst Securities graph which many have used to illustrate the points of my blog. Do you have any data (reports, graphs, news articles) quantifying the number of mortgages that have already been recast or refinanced? I would love for you to share that information with the KCM community so we can talk more intelligently about the subject.

      Reply

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