option ARMs
by John at 9/01/2006 11:21:00 AM
Nightmare Mortgages
This a BusinessWeek article about option ARMs, and how they are devastating to unwise borrowers.
Everybody wants to own a home. It's part of the mythic "American Dream," and I can understand why a person might stretch themselves to purchase a house they cannot really afford, and why, as a first time buyer, they might not have the experience to navigate the home loan market. But more than that, buying real estate has been seen by some as a sure-win investment opportunity for the last several years, and others have been using these option ARMs to refinance exisiting loans so that they can reduce their monthly mortgage payments.
Basically option ARMs are adjustable rate mortgages that allow you to make a monthly payment that is less than the interest due on the loan. Its worse than an interest only loan, in which the principle never goes down; for option ARMs, as you make these low payments, the amount you owe gets larger and larger, instead of smaller and smaller. It's called negative amortization. Also, these loans might have large pre-payment penalties, which prevent you from refinancing your way out of loan when you realize what a bad deal it is. Banks have a lot of reasons for offering these loans (not least of which is the hunger for new customers, including ones who probably shouldn't be getting loans in the first place), and the accounting is screwed up as well (for example, allowing the banks to count the full monthly payment as revenue at that time, even though they only received part of it). But frankly, there are probably only a few customers in the country who should really get one of these loans. Nonetheless, the number of option ARMs has skyrocketed as house prices have gone up, from 0.5% of all mortgages in 2003 to 12.3% in the first half of this year.
The article mentions a couple of people who refi'd their existing low rate fixed mortgage (5.1%, 5.25%! Historically low!) for an option ARM with an insanely low teaser rate (1 or 2%). I don't know the motivation. Maybe they really needed the extra money in their monthly budget because someone was sick or out of a job, or maybe they just wanted to buy more crap. Anyway, they clearly didn't understand the loans they got, because they were then surprised to find out that the low, low interest rates they had were just temporary and that they were actually digging themselves a deeper hole to get out of every month. Normally I take the side of people over corporations, but I have to ask: Which is it - stupid, or greedy?
Anyway, this all ends badly for the borrower. Either they can afford to make their full monthly payment and stop negative amortization (and they are hit with an ARM with rising interest rates), or they can cover the pre-payment penalties and refinance into something sensible. When these folks decide to sell to get out of the terrible loan, they had better hope that they aren't upside-down (owing more on the loan than the value of their home - more than 1/5 of option ARM holders are upside-down already). So they sell and still owe the bank money, or they default and the bank forecloses, or they declare bankruptcy and have to deal with the harsh new bankruptcy laws. The banks and Wall Street are protected because they have the resources and knowlege that lets them manage the risks.
Update: This is related - "Going For Broke: Elizabeth Warren discusses how ordinary families wind up bankrupt and why new legislation could be hurting those at risk."
This a BusinessWeek article about option ARMs, and how they are devastating to unwise borrowers.
Everybody wants to own a home. It's part of the mythic "American Dream," and I can understand why a person might stretch themselves to purchase a house they cannot really afford, and why, as a first time buyer, they might not have the experience to navigate the home loan market. But more than that, buying real estate has been seen by some as a sure-win investment opportunity for the last several years, and others have been using these option ARMs to refinance exisiting loans so that they can reduce their monthly mortgage payments.
Basically option ARMs are adjustable rate mortgages that allow you to make a monthly payment that is less than the interest due on the loan. Its worse than an interest only loan, in which the principle never goes down; for option ARMs, as you make these low payments, the amount you owe gets larger and larger, instead of smaller and smaller. It's called negative amortization. Also, these loans might have large pre-payment penalties, which prevent you from refinancing your way out of loan when you realize what a bad deal it is. Banks have a lot of reasons for offering these loans (not least of which is the hunger for new customers, including ones who probably shouldn't be getting loans in the first place), and the accounting is screwed up as well (for example, allowing the banks to count the full monthly payment as revenue at that time, even though they only received part of it). But frankly, there are probably only a few customers in the country who should really get one of these loans. Nonetheless, the number of option ARMs has skyrocketed as house prices have gone up, from 0.5% of all mortgages in 2003 to 12.3% in the first half of this year.
The article mentions a couple of people who refi'd their existing low rate fixed mortgage (5.1%, 5.25%! Historically low!) for an option ARM with an insanely low teaser rate (1 or 2%). I don't know the motivation. Maybe they really needed the extra money in their monthly budget because someone was sick or out of a job, or maybe they just wanted to buy more crap. Anyway, they clearly didn't understand the loans they got, because they were then surprised to find out that the low, low interest rates they had were just temporary and that they were actually digging themselves a deeper hole to get out of every month. Normally I take the side of people over corporations, but I have to ask: Which is it - stupid, or greedy?
Anyway, this all ends badly for the borrower. Either they can afford to make their full monthly payment and stop negative amortization (and they are hit with an ARM with rising interest rates), or they can cover the pre-payment penalties and refinance into something sensible. When these folks decide to sell to get out of the terrible loan, they had better hope that they aren't upside-down (owing more on the loan than the value of their home - more than 1/5 of option ARM holders are upside-down already). So they sell and still owe the bank money, or they default and the bank forecloses, or they declare bankruptcy and have to deal with the harsh new bankruptcy laws. The banks and Wall Street are protected because they have the resources and knowlege that lets them manage the risks.
Update: This is related - "Going For Broke: Elizabeth Warren discusses how ordinary families wind up bankrupt and why new legislation could be hurting those at risk."
