In a recent column, shortly after Washington Mutual announced it would no longer offer its option adjustable-rate mortgage (ARM) to home buyers, I noted that the program was a benefit to our family because it allowed us to adjust our monthly payments given the educational needs of our four growing children.
I pointed out that three of the four payment options of the option ARM did not render negative amortization, yet too many consumers stayed with the minimum payment for far too long and owed more than they borrowed.
Negative amortization occurs when the monthly loan payment is less than the principal and interest needed to pay off the loan in a specific period of time. The difference is added to the loan amount, so that the borrower owes more than the amount initially borrowed.
What I absolutely underestimated was the percentage of borrowers who took out an option ARM to buy a house they could not afford, or who had no intention of ever leaving the minimum payment portion of the menu and moving into one of the positive-amortization options.
In one of the first significant studies to consider the ramifications of option ARM loans, Barclays Capital revealed that nearly 95 percent of all outstanding option ARM loans "have negatively amortized to some extent" and that the payment shock incurred when the loans reset, or recast, will be far more severe than the highly publicized subprime adjustments.
In a report titled "Option ARM-ageddon: The Real Reset Risk," Barclays Capital researchers predicted that a majority of the existing loans would recast in 2010-11 and monthly payments would jump 60-80 percent. By comparison, most subprime resets should cause only an 8-10 percent payment shock.
The study included several subprime option ARM comparisons, including a $250,000 loan on similar homes in the same neighborhood. While the mortgages carried different interest rates, margins and loan caps, the mortgages were typical for what a borrower could expect. The subprime loan made in 2006 was recast after two years under its original terms and the monthly payment rose from $1,903 to $2,044, or 7.4 percent. The option ARM, recast when the borrower hit the negative amortization ceiling of 115 percent, saw its monthly payments leap 89 percent, from $1,074 to $2,027.
Recasting (or recalculating a loan) is another way of limiting negative amortization and keeping a loan on the original schedule. The main purpose of recasting is to ensure that the loan is paid off within the scheduled amortization period. Option ARM loans are usually recast every five or 10 years (or sooner, if the negative-amortization limit is reached). This recalculation (or re-amortization) is based on the outstanding principal balance, the remaining term and the fully indexed rate. When the loan is recast, the payment required to fully amortize the loan over the remaining term becomes the new minimum payment.
According to the study, even though it is clear that there will be a problem upon recast, option ARM borrowers are not in the position to do anything about it. These borrowers chose this loan for a reason: namely, to purchase a home they could not afford with any other loan. Now that they are already in a home, there is little chance that option ARM borrowers would choose to refinance into a loan that raises their monthly payment. Furthermore, many of these borrowers are locked into these loans due to prepayment penalties. The prepayment penalties are often imposed on borrowers with the lowest FICO scores, meaning that the borrowers least able to afford the payment shock are most trapped in the loan, the research report disclosed.
The Barclays study indicated that between 2008 and 2012, approximately $312 billion in option ARM loans will recast to become fully amortizing loans. The majority of these recasts will come in 2010 and 2011 when $109 billion and $118 billion will recast, respectively. As a result of declining home prices and the negative amortization of these loans, most borrowers resetting in 2010-11 will have loan-to-value ratios in excess of 100 percent.
If you have an option ARM loan, do all you can to move off the minimum payment and on to a disciplined, aggressive, accelerated plan. If can get out of negative territory and start paying down the principal, you might even have some options when you want to refinance.
To get even more valuable advice from Tom, visit his Second Home Center.
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