Toxic Mortgages, The Map of Misery, and Option ARM Hell

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I hate being right sometimes. BusinessWeek’s cover story this week is about Toxic Mortgages; it discusses the problems with Option ARM loans. As I’ve been saying for a few years now, too many people got sucked in by the premise of outstanding rates to help them purchase homes they simply couldn’t afford.

Now, all of a sudden, everyone is talking about it. Where were the publications and the politicians back when this all started? Busy, I guess. The market has topped after years of irrational exuberance, and as you can read from either the Business Week article, or from one of the many housing bubble blogs, things aren’t looking good.

Many of the option ARMs taken out in 2004 and 2005 are resetting at much higher payment schedules — often to the astonishment of people who thought the low installments were fixed for at least five years. And because home prices have leveled off, borrowers can’t count on rising equity to bail them out. What’s more, steep penalties prevent them from refinancing. The most diligent home buyers asked enough questions to know that option ARMs can be fraught with risk. But others, caught up in real estate mania, ignored or failed to appreciate the risk.

Lets take a look at how risky things are (click on map to enlarge):

Florida, Arizona and Washington state have an average of 10-15% of new and refinanced mortgages in the form of ARMs — Nevada averages 20-25% — California averages 25-30%. More astoundingly, “through Mar. 31 of this year, at least 51% of mortgages in West Virginia . . . were option ARMs.”

Worse yet, “Up to 80% of all option ARM borrowers make only the minimum payment each month, according to Fitch Ratings. The rest of the money gets added to the balance of the mortgage, a situation known as negative amortization. And once balances grow to a certain amount, the loans automatically reset at far higher payments. Most of these borrowers aren’t paying down their loans; they’re underpaying them up.”

What does this mean? It means there is a massive percentage of the American population that will likely be facing foreclosure very soon. It means that many hard working people have put themselves in a terrible position because the lending industry is not completely regulated. It means that we are, without a doubt, on the verge of a crisis of unbelievable proportions.

Call me whatever you want, but for the past 3 1/2 years I’ve been warning my friends and family that this would happen. A few listened and locked in 30 year fixed loans . . . a few simply couldn’t afford to buy property (we’re in SoCal after all) . . . a few heeded my advice (very few) . . . and a few are now, like many others, in serious trouble.

I wonder how the new bankruptcy reforms will affect this impending situation.

We’re about to find out!

About Author

Joshua Dorkin

Joshua Dorkin is a serial entrepreneur, investor, podcaster, publisher, educator, and co-author of How to Invest in Real Estate. He started BiggerPockets to help democratize the real estate investing landscape for himself and others, aiming to make it accessible for everyone, regardless of income or education. Today, BiggerPockets is the premier real estate investing website online with over one million members and reaching over 70 million people with the message of financial freedom through real estate investing. Joshua, along with his wife and three daughters, make their home in Denver, Colorado, and spend any time they can traveling, exploring, and adventuring. Read more about Joshua’s story in 5280 and


  1. Joshua,

    I appeciated your post on Business Week’s Toxic Mortgages. Here’s a point of view you might not have heard before.

    I work in the investment side of our industry, and have been using ARM’s since there inception, around the early 90’s. I’ve not had one loan either recast or face foreclosure and I do a fairly solid volume of business in three states.

    The test for the article’s scenario is a bad market. In San Diego we were hit the hardest in the country with the S & L crisis because simultaneously we lost 2-3 of our largest employers to neighboring states. It was a nightmare. Prices dropped from 10-20%, vacancy rates rose from virtually nothing to 10-20%, while rents fell roughly the same amount.

    If you were in an ARM, this simply meant your cash flow turned into a break even. However, if you were in a fixed rate situation you almost for sure were now in a negative cash flow state. Not fun.

    Here’s a quick example showing one of my client’s experience. They’d purchased a couple fourplexes with 10% down, with ARM’s. They had a modest monthly cash flow. About the same time the fourplex across the street was purchased with 20% down and a 30 year fixed rate loan. What happened when it hit the fan?

    My guys went from $400 positive to a break even. The guy across the street went from barely breaking even to losing that same $400 monthly. My folks held on until things righted themselves in late ’95, refinanced, and smiled at their new lower payments. They then exchanged in 1999 into more units doing the same thing, only this time they owned five properties.

    The guy across the street? He got so discouraged he ended up selling his units in the Spring of ’96 and was lucky to get his original money back. He no doubt listened to the media about the ‘evil’ neg-am loans and paid the price.

    Joshua, ARM’s are simply a tool, and like all tools they’re meant to do specific tasks. If your area shows historically for at least the last quarter century that it averages 3% annual appreciation, ARM’s are ok. If however, you’re in East Toilet Seat Oklahoma, it could very possibly end up as you’ve warned your friends. My clients have made a ton using them in growth markets. It’s a tool. You don’t use a hammer to paint a wall.

  2. I enjoy frequenting your blog, and wanted to be sure to share this with you. I am an independent Mortgage Broker with my own company Source Financial LLC, and I wrote an extended response to The Sunday Denver Post’s lead article from September 17, 2006 entitled “No Money Down: A High-Risk Gamble” []. This is along with same lines as the similar fear agenda piece aptly titled “Nightmare Mortgages” that Business Week also recently published.

    I found the Denver Post article to be riddled with misrepresentations, one-sided accountings, and dangerous misinformation, all supporting a traditionalist approach to mortgages that has put two-thirds of all families into home ownership, but yet has led to a situation where the average fifty year-old American is worth negative $7000, only 5% of Americans retire at age 65 in financial dignity, and 9 out of 10 Americans die in debt.

    In reference to my 2000 word response, Denver Post Business Editor Stephen Keating indicated that “I will take the time to read it and digest your observations, and discuss it with the rest of the reporting/editing team here.” Article author and Denver Post Business Writer Greg Grifffin wrote “This is a well-reasoned and well-supported argument. I don’t agree with everything you’ve said, but you’ve managed to get me thinking.” Unfortunately, checking today’s (September 24) Sunday Denver Post and, my response remained unpublished…

    A Response to “No Money Down: A High-Risk Gamble” – The Sunday Denver Post, September 17, 2006 lead article []

    As an independent Mortgage Broker that owns my own company, Source Financial LLC, in addition to being affiliated with a larger mortgage company that handles the processing and servicing of my loans, Lion Financial Corporation, I read the lead article “No Money Down: A High-Risk Gamble” with great interest. Knowing that a lot of folks along the Front Range turn to the Denver Post as an objective source for information, I was shocked and dismayed by much of the information and conclusions that were put forth on a topic that already invokes a fight or flight response among many home owners.

    100% financing loans have been an amazing tool that has greatly contributed to the 5% increase over the last twenty years in percentage of homes occupied by the owner. But it is not the lack of equity that is putting these borrowers into jeopardy, it is a lack of a flexible asset base to deal with changes that has been increasing the risk of these folks defaulting. In general, people that utilize 100% financing for home purchases usually are lacking the liquid assets, emergency funds, and overall wiggle room to deal with financial hardship.

    Of course lenders usually have guidelines concerning liquid asset reserves that must be held by the borrower in order to qualify for a loan, but often they only require enough to cover two to four months of mortgage payments. When people do face catastrophic events rightfully referenced by the Denver Post, “job loss, medical problems and divorce,” those reserves can often quickly disappear.

    But having equity in one’s home when faced with these situations does not “give homeowners options when they face financial problems,” because it is precisely when folks are facing such dilemmas that they are quite often unable to qualify for refinancing, as at that point in time they are too high risk of a borrower for lenders to work with. As a Mortgage Broker I am deeply disturbed by this fact, but unfortunately it is a reality that we all must face when dealing with banks and lenders.

    And probably the most misunderstood aspect of homeownership is the fact that equity is a ZERO PERCENT RETURN INVESTMENT. Yet two-thirds of Americans hold the majority of their wealth in home equity, which is a non-liquid asset that gives them absolutely zero return. Many people confuse appreciation, which is the increase in home value due to market trends, with getting some kind of return on their equity, but that is a common misconception. That is why it is so important for homeowners to separate their equity from their home via refinancing, and put those “cashed out” funds into investment vehicles that offer an actual rate of return. In doing so, homeowners increase their overall liquidity, improve their capacity to face emergencies, reduce their financial risk, increase their rate of return, improve their tax deductions, and diversify their investment portfolio.

    Instead of spending their liquid asset base (savings) to finish their basement and send money to their parents, such as in the case of Jose Garcia and Maria Vanderhorst, borrowers with 100% financing have to exercise greater financial discipline. And putting money down and getting into a 30-year fixed would not have improved their situation, as then their down payment would be tied up as equity, which is a non-liquid asset, money that can only be accessed through refinancing or by selling their home.

    100% finanacing loans are not dangerous, what is dangerous is borrowers not having a liquid asset base to deal with life’s contingencies. Unfortunately, these are the type of borrowers that tend towards 100% financing, as it really is their only option for home ownership. And tying up their wealth in the straightjacket known as equity is not part of the solution, it is part of the problem. An incredible means to access equity for the purpose of greater fiscal flexbility and all the other goods mentioned above, or “cashing out equity as one goes,” is the Option-ARM loan, which received quite a misguided slamming in the Denver Post article.

    The Payment Option Loan gives the borrower four different payment options each and every month: they can make an Interest Only, 30-Year amortized, or 15-Year amortized payment based upon the fully indexed interest rate, or they can make the minimum payment that is based upon a very low “start rate” (usually between 1% and 4%), which involves deferring interest (a.k.a. negative amortization), or adding the difference between the Interest Only payment and the minimum payment onto the principal of the loan. Now while most lenders offer the Payment Option Loan with an adjustable fully indexed rate, one that starts adjusting as early as the first month, some lenders offer the Payment Option Loan with a fixed interest rate for the first five years.

    The Payment Option Loan has proven to be a favorite of Real Estate Investors and Real Estate Agents, as it frees up extra cash flow on a monthly basis for much greater investment opportunities. Knowing that equity is a zero percent return investment is some powerful information to have.

    The annecdote concerning Louis and India Harts conflated the fixed “start rate” with the adjustable “fully indexed rate”, such that readers were left with the impression that the Harts’ interest rate went from 2.6% to 8.1%. The start rate, which determines how much the minimum payment will be, is not a “teaser rate” that “quickly shoots up”. Some lenders do gradually increase the minimum payment itself (not its determining start rate) on an annual basis, usually somwhere in the range of 7.5% per year, to keep the borrower from deferring too much interest. But the start rates is always otherwise a fixed rate. It is the fully indexed rate, upon which the Interest Only, 30-Year amortized, or 15-Year amortized payments are based, that is adjustable is this case. And this fact is consistent with the numbers quoted in the article: the minimum payment of $919 the Harts are making would be the combination of $721 (2.6% start rate on a $180,000 loan) and $198 of escrowed Property Taxes and Hazard Insurance, which is approximately what they would be for such a home.

    In the Harts’ particular case, they are going to have plenty of time to refinance before their loan starts to recast when the principal hits 115% (which would be $207,000 in their situation), as they will be well below that total when their three year prepayment penalty period is up. So the answer to Louis’ “I don’t know how we’re going to do it,” is that when those three years are up, they’ll refinance and get themselves into a loan that they feel more comfortable with and educated about. Though given their situation, if properly understood the Payment Option Loan really is their best option.

    My question is how can mortgage products themselves be blamed for foreclosures? At best the article points towards a correlation, but demonstrating causation surely requires more than offhanded references to what some unnamed experts stated the next wave of defaults “may” come from. Beyond unpredictable catastrophic occurences like job loss and overwhelming medical bills, foreclosures occur because borrowers are getting into loans that they do not understand, and often they do not know that they do not understand the mortgage product. It is the responsibility of the Mortgage Broker to completely explain all the details of any mortgage product to the borrower. But it is also the responsibility of the borrower to be certain that they understand the terms of loan before signing off on it at closing. Vehicles and guns both kill in the range of 35,000 Americans each year, but it is the human misuse due to lack of education, ignorance or simple negligance that creates this reality, much like in the mortgage scenario.

    Every different mortgage product serves its purpose, and what works for one borrower will not work for another given the specifics of their situation. To label certain categories of loans as “high-risk gambles” or as leaving “no room for slips” ignores the millions of families that are in these loans and find that they very much work for them. It is also a disservice to consumers to mislead them with such one-sided representations.

    The true irony of the lead piece in September 17th Sunday Denver Post is that the conclusion that “Option-ARMs… could fuel a surge in foreclosures in the next few years” is the opposite of what we find is actually going on in the mortgage industry, as Payment Option Loans have proven to have the lowest foreclosure rate of any mortgage product currently on the market. World Savings is a bank that specializes in this product, which they refer to as the Pick-A-Pay Loan, as more than 90% of the loans they outfit borrowers with are of the Option-ARM variety. As a lender they have less than a 1% percent foreclosure rate! But World Savings, along with the independent Mortage Brokers like myself that they work with, take on the responsibility of educating the borrowers as to how to properly and smartly manage this incredibly powerful mortgage product.

    A lot of mortgage brokers I know will not touch Payment Option loans, but I believe that is primarily because they are not all that interested in educating the consumer. Why not just throw them into a 30-year fixed APR mortgage? Everyone pretty much knows how that works. But that is also how banks make of the most money off of borrowers! The “list of higher-risk, alternative mortgages” the article refers to are not only not necessarily higher risk (Payment Option loan has the lowest risk, as discussed above), but they also provide the borrower the opportunity to increase their monthly cash flow by lowering their monthly mortgage payments by as much as 40%. In this way consumers are empowered to “become the bank” and grow their own investment portfolio, rather than falling into the trap of handing over their hard earned capital to the banks in the form of a large down payment or paying down principal so that they can have more of a zero percent return investment, equity.

    Affiliates of Lion Financial Corporation, like myself through my company Source Financial LLC, do not shy away from the privilege or responsibility of educating our clients how to properly utilize alternative mortgage packages. And why is this? Because when families are taught smart mortgage product and equity management, they learn to utilize their mortgage as a financial tool for building wealth, which easily makes a $500,000 to $1,000,000 difference for the borrower over the next fifteen to twenty years. The affluent have always understood how to leverage their mortgage, pay as little down as possible, and keep very low monthly payments in order to increase cash flow for investment purposes. The American middle class is being transformed by engaging in these very same concepts and increasing their fiscal discipline, and I absolutely would not have it any other way.

    Brent Ritzel
    President/CEO, Source Financial LLC
    Denver, Colorado, USA
    An affiliate of Lion Financial Corporation
    [email protected]

    P.S. In my former life I was publisher and editor of Zine Guide (the ultimate independent press resource guide from 1997 to 2004) and Tail Spins Magazine (a zine devoted to underground music and bizarre phenomena from 1991 to 2004). I have been highly involved in the international self-publishing community, established the Self-Publishers Event Council of Chicago, and currently teach a course on zines and self-publishing at Naropa University in Boulder, Colorado.

  3. The media loves to latch onto any forecast predicting doom and misfortune. No recent stories have been as ubiquitous in the media as the ones discussing the supposed ‘bursting’ of the housing bubble and so-called toxic, exotic mortgages. Let’s face it, these stories keep appearing because they’re sensational and scary – and let’s not forget, scary reports sell.
    A September 2006 issue of Business Week asks: “How Toxic Is Your Mortgage?” It goes on to talk about deceptive loans, phantom profits and an oncoming wave of defaults. At the center of this discussion in the media is the ‘negative amortization adjustable rate mortgage’. The truth is that no single entity can be blamed for the negative impact this loan has had. A blistering hot housing market, greedy brokers and misinformed home owners have all contributed to what now amounts to a growing epidemic of loan defaults. It doesn’t help that FHA insured financing, with its antiquated requirements and procedures, has forced low income consumers to look for alternative financing. It didn’t take the mortgage market long to meet that need. That’s how the ‘negative amortization adjustable rate mortgage,’ originally intended for high income borrowers with highly liquid assets looking for financing with high cash flow, morphed into a loan being sold to the general public as an affordable loan. Despite all the negative attention this loan receives from the media, we must not forget that a mortgage product is a financial tool that must be applied correctly to serve its purpose.
    From my point of view, from within the mortgage industry, lenders could definitely be doing more to market these loans in a more responsible way. However, consumers need to know that they are putting themselves at risk when they bargain shop or attempt to use online lenders. They’re picking a mortgage based on a set of criteria that may have nothing to do with their overall financial picture. Remember, you get what you pay for. You wouldn’t bargain shop for a doctor if you had a specific malady, you would seek out a professional. So why would you entrust your mortgage (which happens to be the largest financial transaction in most of our lives) to anyone less than a true professional. It is vitally important for the consumer to work with a trusted advisor. Look for an experienced professional who puts advice before price. Consumers should also take it upon themselves to gain a basic understanding of the mortgage process.

  4. These FHA loans and people with low income you talk about in order to get the option arm loan you have to have good credit and at least 10% to put down on a home. So for the poor this loan typically isn’t even available…

  5. DO the math on these loan. If you look at when the majority of people started taking these mortgages starting in 2005. Then calculate the interest rates changing, and (not only negative amortizing at 3%, but now 5%) the 110% cap loans will start recasting late 2007/early 2008. With there loan balance growing, and many markets stagnating or dropping in prices, you will see many people go into forclosure, it will be a very big domino effect to the system.

  6. Hmm… regarding ARMs and such being tools, sure they are, for speculation. Speculation and “investing” is what has destroyed the housing market. Speculation has a history of distributing wealth; from the poor to the rich. So, no argument about them being tools… but they are most definitely not tools that benefit those who need it most.

  7. LOL @ the guy saying equity is a zero return investment. If mortgage rates are 6% then your equity is making 6%. Think about it, the more equity you have the less money you have to hand over to the bank for interest.

  8. The biggest mistake people made was in thinking the increase in values would continue on a straight line. 100% mortgages are no problem as long as your home continues to increase in value but when it stops and you run into problems – it is hard to find a way out.

  9. Option ARM or adjustable rate mortgages can be a nightmare, it has temptingly low minimum payments and it just sucks people in, it’s aimed at cash-strapped homeowners and looks like the perfect pitch, Refinance your mortgage at a bargain rate and cut your payments in half.
    It is the riskiest and most complicated home loan product ever created, stay well clear.

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