You've probably seen the advertisements for payment-option ARMs, or Option ARMs, or Pick-a-Payment mortgages. Generally, they tout the "start rate" of 1.00% or 1.25% and prey on consumer's desire for the lowest guaranteed rate.
"Start Rate", however, is not the interest rate at which you borrow. Start Rate is a mathematical formula to determine the smallest allowable monthly payment that you can make, and not be in default to your lender. Start Rate also increase every year by 7.5%, meaning that a $600 payment grows to $645 in Year 2, $693 in Year 3, $745 in Year 4, and so on. In plain-speak, Start Rate is sort of a gimmick to get you to sign on the dotted line.
That doesn't diminish the usefulness of the product for some borrowers, however. I believe very strongly that the Option ARM is a wonderful mortgage for some borrowers. I only abhor the way that the product is misrepresented in the marketplace.
One of my favorite features about Option ARMs is that the mortgage can negatively amortize. This is concept that gets a lot of bad press, but if you are a regular reader of The Mortgage Reports, you understand why equity is not the Name of the Game in homeownership and why equity is an overrated concept.
In the hands of the wrong homeowner, however, negative amortization is very dangerous. Imagine borrowing $400,000 for your home and then owing $500,000 on the home when you sell it. If you planned for the added debt, no problem! Unfortunately, most people aren't planning for that.
As an aside on this topic, Option ARMs typically require at least 20% downpayment. The larger the loan, the more downpayment is required in terms of percent of home value. A $1,000,000 purchase will often require 25% downpayment. So, even if the loan balance grows, the added debt is still covered by the initial downpayment and the homeowner is not "underwater".
So, when a loan negatively amortizes and the homeowner chooses to sell, he is faced with the possibility that his initial downpayment on the house is cancelled out by the increase in his loan balance. In effect, he made a large equity deposit on the home when he moved in, and when he sells he walks away from the house with nothing.
What the press omits from most Option ARM pieces, though, is that negative amortization is a choice! The reason that the product is called Option ARM or Pick-A-Payment is because the homeowner does not have to make the minimum monthly payment based on Start Rate that may result in a growing loan balance. The homeowner can choose to make full payments on their mortgage every month and never add a dime to their overall debt.
There is a large subset of homeowners for whom the Option ARM is the perfect mortgage product because it offers flexibility for the self-employed or commission-based employee; or because it is a gently-adjusting ARM; or for any other number of reasons.
The press often assumes that every client will fall into a negatively amortizing situation and then will be left owing money to the bank when they sell the home, or worse, that the loan balance will increase to a point that triggers a "recasting" of the loan and the new mortgage payments will be too high to manage. This ultimately results in a foreclosure.
Doomsday scenarios. That is all I ever see in the press about Option ARMs and other negatively-amortizing products. The pressure on lenders about these products is now spilling over into Congress where legislation by financial regulators threatens the future of the Option ARM.
There are plenty of homeowners who use the Option ARM and other negatively-amortizing mortgage products as a way to manage their personal cash flow and their investment objectives. The Doomsday scenario will only be actualized if consumers continue to flock to gimmicky ad campaign (see above) and refuse to ever pay more than their Start Rate.
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