The Next Wave of Bad Loans - Option Arms

A friend of mine in Huntington Beach confided in me that they are in serious trouble with their mortgage. My friends earn good money - and their combined income is a lot higher than the medium level for Orange County; which is high to start with. I'll call my friends Lisa and Jim. They are usually investing successfully in various other commodities, but this time I think they put their home in the position of being an investment vehicle. This time, I think they are in trouble.

Lisa and Jim are in thier late 50’s and early 60’s professionals looking toward retirement in a few years; who refinanced their modest home for $750,000, at the peak of the market with an Option Adjustable Rate Mortgage (Option ARM). This loan program allowed Lisa and Jim to decide monthly which of four optional mortgage plans they would pay, each month. Since getting the loan, Lisa and Jim always chose the lowest payment - which was actually less than the interest they accrued.The plan Lisa and Jim had been to sell their home when he reached 65 and retired relocating to the Palm Springs area or Arizona. This seemed like a well thought out plan which showed they knew what they were doing at the time.

Well, the $2800 monthly mortgage jumped to $3200 with another jump to over $4600 looming in the not too distant future.The problem is that despite what appears to be a path of recovery for the housing industry there are still more than a half million option ARMs that are scheduled to reset in the next four years!

Since many of the Sub Prime mortgages have already failed more and more of the Option ARMs are failing and since February, the Option ARMS have exceeded the default rate on the Sub Prime mortgages.

The sad news for Lisa and Jim is that the home is now only worth approximately $550,000, or less, and the balance of their mortgage has risen to over $800,000; since they only made the minimum payments their principal balance went up every month.Between 2004 and 2007 over $750 Billion in Option ARMs were made and remain at risk. The real kicker is that despite the perfect payment history of many borrowers they still cannot refinance their way out of this mess, as their homes are worth so much less today than when they borrowed the money. About one third of all Option ARMs are currently in default, according to industry analysts.
In comparison to the Sub Prime Mortgages, the borrower of an Option ARM typically had much higher credit scores, better jobs and more to lose than the masses of Sub Prime borrowers who literally walked away from their homes and neighborhoods, in droves. The Option ARMs tend to have higher balances and when they reset have been known to double the initial monthly payment.

The industry is expecting to see 600,000 or more Option ARMs reset in the next 4 years. The four payment plans that Lisa and Jim and other borrowers were offered included the interest only, less than the interest (where the difference would be added onto the principal - OK, when you are accumulating equity every month - but really bites in a declining market), fully amortized over both a 15 year and a 30 year fixed-rate-mortgage.

Over 75% of all borrowers never paid more than the minimal payment - less than the current interest rate plan. This plan was set to reset at either 5 years or when the new principal balance reached a pre-determined level somewhere between 110% and 125% of the original loan. Then once the ‘cap' is reached, borrowers have to pay down a higher balance at a higher interest rate in a shorter time period.

Like so many other exotic loans, they were great products if used properly. What most homeowners in this situation need to do is once every 6 months make at least the regular payment. In most cases this will help the balance on the loan not double and helps to reset the minimum payment due. Consult with your lender to make sure this is what will happen in your case. Unfortunately industry experts expect 81% of the Option ARMs that originated in 2007 to default with many of them ending in foreclosure.

The problem is that the loans were not only offered to those for whom they were designed but to just about everyone with a decent credit score. People were not taking on these loans because they believed their income would grow over time - they were used by homeowners who believed the equity in their house would increase and that they could refinance out of the teaser rates.
The losses from Option ARMs promises to be staggering. Another industry expert is projecting at least $112 Billion will be lost by the banks as a result of Option ARMs written between 2005 and 2007.The good news, if there is any, is that interest rates remain low - so loans are taking longer to reach their cap and will not rest at the higher interest rate until they do reach the cap.