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The Guide to Pick-a-Pay Option ARM Loans

Posted: 26-12-2008 | Views: 190

The Option ARM is one of the most complicated loan programs ever developed. It was heralded as an innovation because it allowed people greater control over their monthly payments, and it provided greater affordability in the early years of the mortgage. It proved to be a complete failure as it experienced the highest default rates of any loan program ever recorded.

Twenty-nine percent of purchase originations nationwide in 2005 were interest-only or Option ARM. The percentage in California was much higher. The proliferation of this product is largely responsible for the extreme prices at the bubble's peak.

The Negative Amortization mortgage (aka, Option ARM or Neg Am) is the riskiest loan imaginable. It has all the risks of an interest-only, adjustable-rate mortgage, but with the added risk of an increasing loan balance. Using this loan, there is the risk of not being able to make the payment at reset, and the borrower is much more at risk of being denied for refinancing because the loan balance can easily exceed the house value. In either case, the home will fall into foreclosure.

An Option ARM loan provides the borrower with 3 different payment options each month: minimum payment, interest-only payment, and a fully amortizing payment. In theory, this loan would be ideal for those with variable income such as sales people or seasonal workers. This assumes the borrower has months where the income is more than the minimum, the borrower sees a need in good times to make more than the minimum payment and the borrower understands the loan. None of these assumptions proved to be true.

When confronted with several different prices for the same asset, people naturally will choose the lowest one. This common-sense idea apparently escaped the innovators who developed the Option ARM. Studies from 2006 showed that 85% of households with an Option ARM only made the minimum payment every month. Many could not afford to pay more, and many more could not see a reason to pay more. Most simply thought they would refinance when the payments got too high.

These loans are also very confusing. The interest rate being charged to the borrower adjusts frequently, and the payment rate (which is not correlated to the actual interest rate being charged) also changes periodically. The separation of the interest rate charged and the interest rate paid is what allows for negative amortization, and it also creates a great deal of confusion.

The use of negative amortization loans with artificially low teaser rates allowed borrowers to obtain double the loan amount with the same monthly payment: double the loan; double the purchase price. This is how prices were bid up so high so fast without a commensurate increase in wages during the Great Housing Bubble. The elimination of these loans is also the reason prices collapsed.

The Option ARM should never have been offered to the general public. It is a niche product that only the very financially savvy can handle. It was not offered to the general public before the Great Housing Bubble, and due to its astronomical default rate, it will probably never be offered again.

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