Payment shock high on new adjustable mortgage

How borrowers get into trouble

“Bear Stearns is offering what they call a “Secure Option ARM” on which the starting interest rate is fixed for five years. Your opinion?”

I have mixed feelings about this new version of a mortgage that is now causing enormous grief among many people who have them. During 2005-2006, about half a trillion dollars of option ARMs were written, and many of those who took them are very unhappy today.

No day goes by that I do not hear from option ARM borrowers who are waking up to the realization that they have a tiger by the tail that is soon going to bite them. The very low mortgage payment that sucked them in has resulted in a growing loan balance, and soon their payment is going to jump to the level needed to pay off that swollen balance. The payment increases that loom on their horizons can be frighteningly large, and most of those who write me are justifiably frightened. 

What these borrowers can or can’t do to extricate themselves is a topic for another article (or 10). The focus of this article is whether borrowers are less likely to be led astray by the new version of the option ARM than by the old one.

Both versions offer the same four payment options:

  • Minimum payment, which doesn’t cover the interest, resulting in a rising balance.

  • Interest-only payment, which results in a constant balance.

  • Fully amortizing payment on a 30-year schedule, which results in a declining balance.

  • Fully amortizing payment on a 15-year schedule, which results in a more rapidly declining balance.

Of course, the great majority of borrowers select the minimum-payment option, which is the one that gets them into trouble.

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On the positive side, the initial interest rate on the new option ARM is fixed for five years, instead of adjusting monthly as on the old version. This makes the new version easier to understand and more transparent.

The minimum payment on the new version is calculated at a rate that is 3 percentage points below the interest rate. Here is an example taken from Amerisave.com, which offers it. The lowest rate on Feb. 20 was 5.875 percent, with an initial payment on a $100,000 loan of $240, calculated at 2.875 percent. The difference between interest calculated at 2.875 percent and interest calculated at 5.875 percent is added to the balance, which grows every month. However, the balance cannot exceed 115 percent of the original balance, or $115,000. This is the “negative amortization cap.”

The potential future payment shock is actually greater on the new than on the old version. However, on the new version, the borrower can know exactly when the shock will occur and exactly how large it will be.

In my example, if the borrower makes the minimum payment every month, the balance hits $115,000 in month 52. At that point, the minimum payment, still interest-only, is recalculated at the actual interest rate of 5.875 percent. The new interest-only payment is $563, which is 135 percent above the previous payment. Because the interest rate is fixed for five years, the borrower can know this in advance and has 52 months to get ready.

Starting in month 61, the borrower must contend with uncertainty because the first rate adjustment occurs and the new payment will depend in part on what happens to interest rates. While we can’t forecast interest rates five years ahead, we can calculate what will happen on different interest-rate scenarios.

One useful scenario assumes that the current index value used by the option ARM doesn’t change from its current value of 5.377 percent. Adding the margin of 2.25 percent to this gives a rate of 7.627 percent in month 61. The interest-only payment would be $731, which would hold for the next five years. In month 121, the payment would be recalculated to pay off the $115,000 balance over the remaining 20 years at 7.627 percent. This payment would be $935. Of course, if interest rates rise, the payments would be higher, and vice versa.

The new option ARM has greater transparency than the old one, but will borrowers look? Will loan officers and mortgage brokers tell them what to expect? Will servicing agents keep them informed on the status of their loan and what they can expect down the road?

Sadly, the answer to all these questions is largely “no.” Loan providers operate in a sales mode, and warning potential borrowers that bad things may lurk ahead does not facilitate sales. As for servicing agents, there is no money to be made in keeping borrowers informed, so don’t expect any help from that quarter.

The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.

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