What is an Option Arm?

It is an ARM on which the interest rate adjusts monthly and the payment adjusts annually, with borrowers offered options on how large a payment they will make. The options include interest-only, and a “minimum” payment that is usually less than the interest-only payment. The minimum payment option results in a growing loan balance, termed “negative amortization”.

Now a couple things to remember about Option ARMs:

• They are not “Subprime” loans
• The effect of Option ARMs has yet to fully hit the market
• Owners are typically locked in and unable to refinance due to fine print

As BusinessWeek put it:

For cash-strapped homeowners, it was a pitch they couldn’t refuse: Refinance your mortgage at a bargain rate and cut your payments in half. New home buyers, stretching to afford something in a super-heated market, didn’t even need to produce documentation, much less a downpayment.

Those who took the bait are in for a nasty surprise. While many Americans have started to worry about falling home prices, borrowers who jumped into so-called option ARM loans have another, more urgent problem: payments that are about to skyrocket.

…

The bill is coming due. Many of the option ARMs taken out in 2004 and 2005 are resetting at much higher payment schedules — often to the astonishment of people who thought the low installments were fixed for at least five years. And because home prices have leveled off, borrowers can’t count on rising equity to bail them out. What’s more, steep penalties prevent them from refinancing. The most diligent home buyers asked enough questions to know that option ARMs can be fraught with risk. But others, caught up in real estate mania, ignored or failed to appreciate the risk.

There was plenty more going on behind the scenes they didn’t know about, either: that their broker was paid more to sell option ARMs than other mortgages; that their lender is allowed to claim the full monthly payment as revenue on its books even when borrowers choose to pay much less; that the loan’s interest rates and up-front fees might not have been set by their bank but rather by a hedge fund; and that they’ll soon be confronted with the choice of coughing up higher payments or coughing up their home. The option ARM is “like the neutron bomb,” says George McCarthy, a housing economist at New York’s Ford Foundation. “It’s going to kill all the people but leave the houses standing.”

Stories Of Those Who Have Faced Option ARM Nightmares

Gordon Burger

Gordon Burger is among the first wave of option ARM casualties. The 42-year-old police officer from a suburb of Sacramento, Calif., is stuck in a new mortgage that’s making him poorer by the month. Burger, a solid earner with clean credit, has bought and sold several houses in the past. In February he got a flyer from a broker advertising an interest rate of 2.2%. It was an unbeatable opportunity, he thought. If he refinanced the mortgage on his $500,000 home into an option ARM, he could save $14,000 in interest payments over three years. Burger quickly pulled the trigger, switching out of his 5.1% fixed-rate loan. “The payment schedule looked like what we talked about, so I just started signing away,” says Burger. He didn’t read the fine print.

After two months Burger noticed that the minimum payment of $1,697 was actually adding $1,000 to his balance every month. “I’m not making any ground on this house; it’s a loss every month,” he says. He says he was told by his lender, Minneapolis-based Homecoming Financial, a unit of Residential Capital, the nation’s fifth-largest mortgage shop, that he’d have to pay more than $10,000 in prepayment penalties to refinance out of the loan. If he’s unhappy, he should take it up with his broker, the bank said. “They know they’re selling crap, and they’re doing it in a way that’s very deceiving,” he says. “Unfortunately, I got sucked into it.” In a written statement, Residential said it couldn’t comment on Burger’s loan but that “each mortgage is designed to meet the specific financial needs of a consumer.”

Harold X

There’s no way to camouflage what Harold, a former computer technician, is about to face. He’s disabled and has one source of income: the $1,600 per month he receives in Social Security disability payments. In September, 2005, Harold refinanced out of a fixed-rate mortgage and into an option ARM for his $150,000 home in Chicago. The minimum monthly payment for the first year is $899, which he can afford. The interest-only payment is $1,329, which he can’t. The fully amortized payment is $1,454, which his lender, Washington Mutual (WM ), gets to count on its books.

WaMu, no fly-by-night operation, said it couldn’t comment on Harold’s case, citing confidentiality issues. A spokesman says the bank “accounts for its option ARM product in accordance with generally accepted accounting principles.” WaMu has about $12 billion in loans negatively amortizing right now, up from $2.5 billion in 2005, estimates CreditSights’ Hendler.

In a written statement, WaMu said “borrowers who request an adjustable loan with payment options should understand those options and potential adjustments throughout the life of the loan. We make detailed disclosures to customers that are designed to develop a more informed consumer of mortgage products and ensure that our customers are comfortable with the loan products they select.”

The Shaws

Billy and Carolyn Shaw are among the growing ranks of borrowers who have taken out loans they say they didn’t understand. The retired couple from the Salinas (Calif.) area needed to tap about $50,000 in equity from their $385,000 home to cover mounting expenses. Billy, 66, a retired mechanic, has diabetes. Carolyn, 61, has been caring for her grandchildren, 10-year-old twins, since her daughter’s death in 2000.

The Shaws have a fixed income of $3,000 a month that will fall by about $1,000 in November after Billy’s disability benefits run out. Their new loan’s minimum payment of about $1,413 is manageable so far, but the fully amortized amount of about $3,329 is out of the question. In a little over a year, they’ve added some $8,500 to their loan balance and now face a big reset if they continue to pay only the minimum.

“We didn’t totally understand what was taking place,” says Carolyn. “You have to pay attention. We didn’t, and we’re really stuck here.” The Shaws’ lender, Golden West, says it routinely calls customers to ask them if they are happy and understand their mortgage loan.

The Hinz’s

Jennifer and Eric Hinz of Somerset, Wis., are feeling the squeeze. They refinanced out of a 5.25% fixed-rate, 30-year loan in June, 2005, and into an option ARM with a 1% teaser rate from Indymac Bank. The $1,483 payment for their original mortgage dropped to as low as $747 with the new option ARM. They say they had no idea when they signed up, however, that the low payment adds $600 in deferred interest to their balance every month.

Worse, they thought the 1% would last three years, but they’re already paying 7.68%. “What reasonable human being would ever knowingly give up a 5.25% fixed-rate for what we’re getting now?” says Eric, 36, who works in commercial construction. Refinancing is out because they can’t afford the $15,000 or so in fees. “I’m paying more, and the interest is just going up and up and up,” says Jennifer, 34, a stay-at-home mom. “I feel like we got totally screwed.” They say their mortgage broker has stopped returning their phone calls. Indymac declined to comment on the loan’s specifics.

Tags: arizona, real estate, housing bubble, foreclosure, adjustable rate mortgage, arm, option arm, refinance, home equity, subprime