Option Arms – the Big Bang That Didn’t Come (Yet)

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Josh Dorkin and I have both previously blogged about the looming threat posed by “option arm” loans, sometimes cutely called “pick-a-pay” loans. These are loans in which borrowers can decide how much to pay each month, with many predictably going for the minimum payment option.

The Downside Possibilities

What many borrowers may not have fully understood when they signed on the dotted line was that such loans have a potentially dangerous negative amortization feature, i.e., the principal balance increases when only the minimum payment is made. Thus, many borrowers ended up with principal balances more than the original loan – meaning that they had less “skin in the game” every month, and even more incentive to default in a declining market like we’ve seen for the past several years.

On top of the negative amortization, option arms had yet another nasty catch – the teaser period only lasted for a set number of years or until a certain amount of negative equity was hit. The common fear of sensible borrowers (which I shared) was that the rate environment would have increased by the time the teaser periods were over, requiring borrowers fork over massively increased payments. But, thanks to the recession and the Federal government’s ever-increasing activism pushing down the cost of funds, these initial fears have proven to be overblown in hindsight, as pointed out by a recent Los Angeles Times article.

Where are we Today?

Indeed, now that rates are near their all time lows in recent memory, people who (perhaps unwisely at the time) took out option arms are laughing all the way to the bank – as the LA Times reports, “the fully adjusted market rate on many option ARMs is now about 3.5%,” citing Barclays Capital analyst Sandipan Deb.

It is almost enough to make me wish I’d signed up for a few of these loans instead of my fuddy-duddy thirty year fixed conventional loans. But not so fast. As the same article points out, a rising rate environment (which virtually everybody is forecasting these days) may make the option arms into exploding mortgages – provided that the lenders and borrowers don’t get together right now and work out some kind of alternative arrangement. Don’t say we didn’t tell you so.

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