So finally numbers are starting to consistently reflect what many observers have been warning everyone online about….Housing Doom ahead. A number of news articles have been documenting the downfall in prices, subprime crashes, short sales and foreclosures around the country. My heart goes out to all of those families who bought into the American Dream to only have it snatched away from them.
Lending practices has enabled families to buy a home who normally wouldn’t be able to afford it. This is great but the terms that they were offered is bad news. Never before have there been such confusing loans brought into the market, especially a loan that was normally not given to the ‘ordinary’ American but the ‘well off’. It is called the Option ARM.
Option Adjust Rate Mortgage (ARM) – this may be one of the riskiest and complicated home loan products ever created. It has low minimum payments because it’s a hybrid between an ARM (low fixed rate for a few years) with a negative amortization loan that lets borrowers have the option to pay less than the full amount of the interest owed on each payment. The borrower decides how much they want to pay from a list of of options supplied by the lender (usually from 4 different payment schedules such as 20 year fixed, 30 year fixed, interest only, negative amortization) . The amount not paid is tacked on to the total mortgage owed. The minimum payment is usually so low that the borrower ends up owing more on the home.
Why is this a Mortgage Product Monster?
For the borrower: Many of the option ARMs are starting to reset this year with much higher payment schedules. And worse yet, because home prices have leveled off, borrowers will not be able to count on the rising equity to bail them out. If the borrower has a pre-payment penalty, they won’t be able to refinance out of the mortgage without paying a fee that could range from $10,000 to much more.
For the lender: Brokers were paid more to sell these loans and the lenders were allowed to claim the full monthly payment as revenue even when the borrower didn’t pay the full amount. The interest rate and upfront fees were probably not set by the lender but rather by a hedge fund. Analysts estimate that 1.3 million borrowers signed up for almost $389 billion in Option ARMs in 2004 and 2005 alone. Numbers show that up to 80% of all Option ARM borrowers make only the minimum payment each month.
Conclusion: It smells like a disaster. Sadly, borrowers will be burdened with the most pain and not the lenders. The borrowers will be expected to pay for the higher payments or cough up their homes.
See if you’re at risk
You may be at risk if you:
1) Exaggerated your income on your application. A lot of times, lenders do not verify stated income loans. If your income is inflated, you will not be able to keep up with the payments when your loan resets and payments go up.
2) You only make the minimum payments each month. Not paying down your debt only increases it each month. Before you know it, the total amount you need to pay on the house is MUCH more than you anticipated.
3) You’re getting close to reaching the principal cap your lender set. Negative Amortization cannot go on forever. Your lender set a cap on the amount you owe and limits how long negative amortization can go. If you reach the cap, your minimum monthly payments can potentially more than double.
4) Home values in your neighborhood are falling. Falling or stagnant home prices could fall below how much you owe. You end up in a tough situation where you can’t afford to refinance the mortgage or sell the house, unless you have some extra cash or additional equity in your home to cover those expenses.
What can you do? Make at least the interest-only payment, refinance the loan or sell the house to pay off the mortgage. If you do end up making the interest-only payment, you are at least staying afloat instead of sinking by at least not adding to the principal. If you do refinance the loan, try to go with another lender if you didn’t feel like your current lender explained the Option ARM loan well in the first place.