The Option ARM Loan - A Useful Tool That Has Been Abused

Included in all the news about the mortgage crisis are stories
of borrowers who have been taken advantage of by being
placed in inappropriate loan products. Perhaps the program
that is most misunderstood, and prone to abuse is the one
known as the Option ARM (for adjustable rate mortgage).

This loan is also known as a 4-pay ARM, or a negative
amortization ARM, or a deferred interest option ARM,
and it is distinct in the marketplace for using non-traditional
features to help clients in certain circumstances.

When the use of this mortgage became more widespread,
when the underwriting guidelines of the lenders became
less strict, and when the sale of this product was offered
to borrowers who were either led astray, or did not
understand what they were getting, the seeds of future
problems were planted.

When the real estate values began to take a downturn,
and borrowers had used the Option ARM to finance their
homes with very little down payment, these problems
began to bloom as part of the garden of the mortgage
crisis that we are working our way through now.

Let's go over the major features of this loan and how it
is different so that you have a thorough understanding
of how it works.

The traditional thirty year mortgage creates payments
that are split between the interest owing on the loan
and some contribution to the principal balance, decreasing
the loan balance over time. This calculation of equal
payments to retire the loan over the term of the loan is
known as amortization.

The Option ARM allows the minimum payment to be created
using a low, introductory interest rate. After the first month,
this minimum payment no longer has any direct association
with the interest rate calculation on the loan for the next five
years.

So, the first thing you need to understand is that the minimum
payments and the interest rate are operating under two entirely
different calculations, and that they are no longer tied directly
together.

The minimum payments will continue with a specified increase
on an annual basis, usually 7.5% of the original payment. For
example, if the first year payment was $1,000 per month, the
minimum payment in the second year will be $1,075, the third
year $1,156 per month, the fourth year $1,242 and the fifth
year $1,335 per month. At the end of each five years, there
is a provision for a reset of the payments, which I will discuss
later.

The interest rate begins with the below-market, introductory rate
and after the first month the interest rate will be determined
by a combination of an independent index value derived from
the financial markets and a margin determined by the lender
(you can think of that as the lender's profit margin). So,
every month the loan will probably have at least a slightly
different interest rate that will determine how much interest
is owed for that month.

As an example, when these loans were most aggressively
marketed, the introductory rate was 1.0%. Many lenders
used an index known as the Monthly Treasury Average index.
This was derived from data from the Federal Government that
the lender had no control over, but was accepted as a reasonable
measure to determine whether rates were higher or lower.
It averaged the last 12 months treasury figures to determine
the index value. Next month it would include the newest figure
and drop the oldest one, so it would still average the most recent
12 months of data. Today's 12 Month Treasury Average figure is
4.69%.

The lender offered their loans using this index an adding a margin.
A common margin was say, 2.5%.

So, the borrower received a 1.0% interest rate for the first month.
In month two, the rate is no longer 1.0%, but is now calculated
based on index plus margin: 4.69% + 2.5% = 7.19%.

Let's bring all of this together. A loan amount of approximately
$311,000 at 1.0% gives us an amortized payment of $1,000
approximately. This means in the first month, the borrower is
actually paying $259 in interest, and $741 in principal. (So
we don't get bogged down in precise numbers, let's act as
if the loan remains at $311,000 as we work through the example).

In month two, the introductory rate is gone, and the new interest
rate is now 7.19%. The borrower is still allowed to make his
minimum payment of $1,000, but now the interest that is owing
on this loan is $1,863. If the borrower makes the minimum
payment, the unpaid interest of $863 will be added to the
principal balance owing meaning that he would now owe more
than he originally borrowed.

If interest rates continue to rise, the difference between the
minimum payment and the interest accruing on the loan will
increase. If interest rates go down, the interest owing will
get closer to the minimum payment.

This is why this loan is called the Option ARM. The borrower
has the option to pay the minimum payment of $1,000, or an
interest only payment of $1,863. In addition, the lender will
offer the borrower two additional choices of a 30-year amortized
payment ($2,104) or a 15-year amortized payment ($2,822).
That is how it gets the name of the 4-pay ARM. And because
the borrower may allow his principal balance to increase due
to the deferred interest, the terms "negative amortization" and
"deferred interest option ARM" are also used to describe this
loan.

The lenders have built in some mechanisms so that the loan
doesn't spiral out of control without an attempt to rein it in.
Every five years, there will be a reset or recasting of the
payment to bring it back to reality. At that time, the unpaid
balance, at the interest rate calculated at that point, and
using the 25 years remaining on the loan will determine the
new minimum monthly payment irrespective of the 7.5%
limitation allowed in the first five years.

Using our example, if the borrower chose to pay the interest
payment and if interest rates remained constant at the 7.19%
(impossible, but useful for this illustration), the new minimum
payment at the end of five years would be $2,236 ($311,000
at 7.19% over 25 years).

If the borrower elected to defer the $863 per month over those
five years, he would owe something over $362,000, creating
a new minimum payment of at least $2,455. (I am ignoring
the effect of compounding on the deferred interest in order
to make this easy and simplify the concept).

You can see that if a borrower was only able to budget $1,000
per month, there will be a tremendous payment shock at the
end of five years if their new payment is now $2,455.

In the next issue, I will go into more discussion of this loan.
It has a suitable purpose for specific situations, and its
overuse helped unknowledgeable borrowers get into deep
financial trouble.