Option ARM Mortgages Represent Ticking Time Bomb
Option Adjustable Rate Mortgages (ARMs) were just one of many innovative financial products that rose to the fore during the housing bubble. They work by enabling borrowers to select from three options, the size of the payment they wish to make on their mortgage each month. The high payment is fully-amortizing (principal and interest), the middle payment is interest only, and the low payment is a token sum which does not even cover interest. That the bast majority such borrowers opted to make the low payment has led to the characterization of the Option ARM as the Negative Amortization ARM.
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.