Many ARM borrowers actually caught a break after the housing bubble burst, since the consequent lowering of interest rates brought ARM rates down proportionately. Gushed one borrower, whose rate is tied to LIBOR, ““In 2009 I found out I have a 2.5 percent mortgage. That’s not onerous by any standards.” Unfortunately, lower interest rates doesn’t necessarily translate into lower payments.

There is a clause in most Option ARM contracts which states that if/when the loan reaches 60 months in age and/or the balance reaches a cap (110% – 125%), the loan automatically recasts. Essentially what this means is that the borrower must begin to make fully amortizing principal and interest payments; the minimum negative amortizing payment is no longer an option.

Due both to the decline in housing prices and the fact that most Option ARM borrowers elected to make the lowest payments, recasts are beginning to rise. 2011 meanwhile, will likely witness an explosion in recasts, as loans cross the 60-month time limit. According to a recent report by Fitch Ratings, this figure could be as high as 70%. Moreover, “Of the $189 billion securitized Option ARM loans outstanding, 88% have yet to experience a recast event. Of these loans that have not yet recast, 94% have utilized the minimum monthly payment to allow their loans to negatively amortize.”

For a significant portion of Option ARM borrowers, a recast is tantamount to a death sentence. Fitch predicts that ultimately, close to half of such borrowers could default on their mortgages. “They’re probably going to default at a rate that makes subprime look like a walk in the park,” warned one analyst. When you consider that as much as 14% of outstanding mortgages are Option ARMs and that most were used to purchase homes in bubble markets (California, Florida, Nevada, Arizona), the losses will probably be staggering.

Ironically, holders of Option ARMs don’t have many Options when it comes to mitigating the burdens posed by their mortgages. While refinancing could save money over the long-term, it would probably won’t help those who are currently struggling: “Just about anything they refinance into is going to give them higher payments than they have now,” explained one counselor.

Mortgage modifications, meanwhile, are also pretty much off the table, since they are intended to lower one’s mortgage rate rather than to lower one’s payment, directly. ” ‘The problem with these option ARM borrowers is they are already paying a low rate,’ [Barclays Analyst] Deb said, adding that a better solution would involve forgiving part of the loan balance, something that most lenders have been unwilling to do.” Still, if you’re facing such a predicament, it wouldn’t hurt to talk to your lender. As the problems surrounding Option ARMs become more prominent, lenders might become increasingly keen to play ball.

Before I get ahead of myself, let me first briefly explain what exactly is meant by the term balloon mortgage. In a nutshell, it’s a “mortgage which does not fully amortize over the term of the note, thus leaving a balance due at maturity.” While the borrower makes payments (interest and principal) in accordance with a normal 15 or 30 year amortization schedule, the loan must be paid off after a fixed duration, usually 5 or 7 years. This lump-sum payment of the remaining balance is known as a “balloon.”

Irrespective of the size of the downpayment, balloon mortgages are still considered risky by most experts. The reason being that the average borrower won’t be able to afford the balloon payment, and will be forced into refinancing. If interest rates have increased and/or the borrower’s credit has deteriorated in the interim period, then this could prove both difficult and expensive. For this reason, balloon mortgages have received special scrutiny from regulators. “Under the new Fed proposals…Buyers also would be presented with a one-page document, in question-and-answer format, warning about risky loan features such as negative amortization and balloon payments…”

The main advantage of the balloon mortgage (cynics would say ‘the main way that lenders entice borrowers’) is its initial interest rate, which can be significantly lower than prevailing fixed rates. Even adjustable rate mortgages, which are similar in many respects, carry higher rates than balloon mortgages. However, interest rate increases are usually capped for ARMs, whereas balloon mortgages must be refinanced at the market rate. There are also closing costs associated with this refinancing, whereas ARMs carry any additional costs unless the borrower elects to refinance. Factor in prepayment penalties and extra mortgage payments, and it becomes a mystery why anyone would still be foolish enough to gamble with a balloon mortgage.

In other words, both banks and homebuyers are increasingly unwilling to assume the risks associated with a mortgage product that has been connected with notorious uncertainty and even “failure.” Among prime borrowers, the difference in the delinquency rate for one state between fixed-rate and adjustable-rate borrowers is over 5%, such that prime ARM borrowers are 3 times as likely to become delinquent. The sub prime numbers are even more grim: “Nationally, 48 percent of subprime ARM loans were at least one payment past due.”

Gone are glory days for the “pay option ARM,” the “interest-only ARM,” and the ever popular “hybrid ARM,” all of which rely on tantalizingly low initial rates (and low interest payments) to attract borrowers. The problem with these loans is that they assume that benchmark rates would remain low, while home prices would remain high. In hindsight, both of these assumptions were erroneous- though it is worth noting short-term rates have come down slightly over the past year after exploding in 2007.

[In industry parlance, the initial rate is known as the teaser rate. After a certain period of time, the interest rate is permitted to fluctuate (based on a spread to an interest rate index), but it is usually restricted by a periodic cap and lifetime cap, both of which are designed to prevent rates from rising (or falling) dramatically]. Some unscrupulous banks sold ARMs with very high caps, which resulted in a skyrocketing interest rate and monthly payment after the teaser rate expired.

Another questionable assumption was that borrowers could refinance at a comparatively low, fixed-rate as soon as their adjustable rate began to rise. For example, with a 5/1 hybrid ARM, as long as you successfully refinance within five years (at which point the interest rate switches from fixed to floating), you are theoretically protected from the inevitable rate hike. However, borrowers with declining home prices (the vast majority) are now learning that this is far from easy.

For those of you with ARMs that haven’t yet reset, it might be advisable to look into refinancing. While rates are currently low – the average adjustable rate is 4.69% for one year and 4.82% for five year, it’s any one’s guess as to how long they will stay low. If rates do climb, you will find yourself facing a “payment shock,” especially if the caps on your interest rate aren’t favorable. With 30-year fixed rate currently around the same level as adjustable rates, why take the chance? The only real exceptions are borrowers who plan to sell their house before the interest rate resets and those seeking nonconforming loans- i.e. for mortgages greater than 417,000.

Even if circumstances suggest fraud when a loan was made, lawyers say, the various parties protect each other by refusing to produce documents.

Compounding the problem is a law stating that when a loan is passed to another party, that entity cannot be held liable for problems.

Even if the mortgage brokers outright lied to sell it, the consumer is stuck footing the bill until their house is foreclosed upon.

A borrower in good standing since 1998, she said a local broker persuaded her to combine her debts in a fixed-rate loan of $65,000 in 2003.

But at the closing, she was presented with an adjustable-rate mortgage from the Argent Mortgage Company, carrying a low teaser rate for two years. When she objected, the broker assured her that rates would fall and she could get a better fixed-rate loan later. She said she believed him.

The bait and switch pricing fraud may not be a few isolated incidents. In some cases, deceptive pricing may actually be a market standard. Last year the Pittsburgh Post Gazette published an article highlighting that Bankrate advertisers may offer one price on the Bankrate site, then charged another when consumers clicked through to the end merchant site.

If a consumer gets scammed it is their fault and they are stuck paying it. There is virtually no protection against mortgage fraud, especially for poor citizens who do not have enough capital to sue and reshape broken laws. Pretty sick, especially considering that the 2005 consumer bankruptcy bill was drafted by MBNA.