Option ARMs leave many with few options
In recent years a mortgage product called an “option ARM” has been a very popular loan product. In fact, I even had one myself for a short period. At the time it was a smart move financially, saving me thousands of dollars in interest when rates were falling like autumn leaves.
But option ARMs are a very complex financial product, and not for those who can’t be bothered to read the fine print.
In addition, while they are wonderful for the consumer when rates are falling, they are very hazardous to your financial health when rates are rising. What’s worse, millions of people have these loans and do not realize the hole they are digging themselves into.
For starters, option ARMs generally have two rates attached to them. The first (and the one that is widely advertised) is the “pay rate.” This is generally very low in the beginning and may be low for several years. This allows the consumer to, in theory, buy more house for less monthly payment.
But in the fine print is the hidden second rate, and that is the actual rate at which the interest is accruing. In addition, the second accrual rate may be set for a certain period of time such as three months up to a year.
What this means is that these loans are capable of a little trick called “negative amortization” and that is something few homeowners understand. It is what is behind the abnormally high rate of foreclosures that is hitting the nation right now.
Let’s look at an example. Say your friend Joe gets a mailer from a mortgage company offering him the amazing rate of 1.99 percent on his mortgage. Who wouldn’t want a deal like that? The ad may even say, “This is not a one-month adjustable, not a one-year adjustable…the rate is fixed for five years!” That would be a truly awesome loan and if it were true I’d be the first one on the phone signing up for it.
In addition the loan may have some attractive options to it, meaning Joe can choose from several different payment schedules at will. Joe may be able to pay interest only, pay a 15-year amortization payment or a 30-year payment.
So while he is planning what to do with all the money he will save, Joe gets these guys on the line and ask how quick they can get it done. Let’s assume Joe has a $400,000 loan that he is paying 6 percent on, with a principal-and-interest payment of $2,392.20 per month. A cheery voice on the phone tells him they can lower that baby down to $1,476 a month at 1.99 percent. Cool, he says, let’s do it!
And true to their word, Joe signs the loan documents, which say his payment will be $1,476 a month, and he starts checking into vacations on Maui. Life is looking good!
But after about three months he notices something funny on his statement. There are some percentages there that look way higher than 1.99 percent (like say 8 percent), and all of a sudden his loan balance starts going up every month by about $2,000. What the heck, he asks himself.
Let’s assume he thinks it’s a computer glitch and with the kids starting school and the holidays coming up, he assumes that great big bank will sort it out in due time. Being a busy guy, Joe decided to put the thing on auto-draft and doesn’t even bother looking at his statements because he knows the house payment is getting made. So he doesn’t give it a thought for a few years.
One day Joe gets an important-looking letter from his lender. In it the lender announces that Joe’s payment has changed because the 1.99 percent period is over, and his new payment will be $3,228 per month. And by the way,, his loan balance is now $440,000.
Thinking this must surely be a mistake, Joe digs out his loan papers and tries to figure out what happened. Here is what happened: his loan was racking up interest at 8 percent while he was only paying interest at 1.99 percent. The difference (in two years $40,000) gets added to his loan balance and he pays interest on top of interest. Suddenly it’s time to pay the piper and it’s one heck of a nasty bill.
I don’t mean to make the above sound like I am mocking Joe for being naïve, but the truth is most individuals do not “get” what is happening to them and I can guarantee you the above scenario is playing itself out with a lot of homeowners every month.
So what does someone in this situation do? If you are living in this valley you likely have enough built up equity to refinance and lower your payments, though the $40,000 is gone forever.
But if you were one of millions of homeowners who got such a loan with little or nothing down and your property value has been flat, you have one heck of a problem as it may be impossible to refinance. If you can’t make the higher payment you are really in upside down ” and that is why there are so many foreclosures going on.
If you suspect you have such a loan and have any questions about it whatsoever it is very important you get some good advice on the impact of the terms of this loan. Losing your home is a very difficult thing and something I would not wish on anyone, but it’s happening at an alarming rate and in many cases it could be prevented.
Chris Neuswanger can be reached at Macro Financial Group in Avon at 970-748-0342 and welcomes mortgage-related inquiries from readers. His e-mail is firstname.lastname@example.org.