Definition. An Option ARM mortgage loan is a "Negative Amortization Mortgage," which means that if the borrower only pays the minimum payment each month, the principal will build. By definition, a negative amortization mortgage is one, which has a low monthly payment that does not fully cover the accrued interest each month. Since the interest is not being fully paid, the difference between what is paid and the interest accruing is added to the balance of the loan.
If only the minimum payment is paid, after 3 year or so, the loan will recast, which means that the outstanding balance will amortize over the remaining 27 years (37-years in the case of the 40-year loan), and the payments will double possibly triple versus the minimum payment the borrower has been enjoying. Just before the point of recast, the borrower has a few choices, namely: 1) cough up some cash to pay down the balance that has been building, 2) take on the big payments, or 3) refinance into another Option ARM to get another 3-years of low payments. Option 1 and 2 may not be feasible for most borrowers. Option 3, refinancing, may be possible if the borrower has maintained good credit since last refinance (or purchase loan) and market values have not dropped.
Poor Spending Habits. Folks that refinance every few years to pay off their maxed out credit cards will fail (no matter what type of mortgage they obtain) when the market values soften and the equity is not available to tap. Refinancing to correct poor spending habits is seldom a long-term solution unless the borrower truely changes their spending habits. With foreclosures running 30% ahead of 2006 figures, most mortgage defaults are attributed to these individuals. These borrowers took on traditional (non-Option ARM) high loan-to-value (LTV) loans with high rates just to get into their home or investment property.
Market Devaluation. In California and Florida, property values have dropped more than the rest of the country; real estate equity is running low, or is even negative meaning that the mortgages are greater than the property value. These property owners that originally obtained 80% to 100% financing, are now sitting at loan-to-values of 100% to 120% based on current values. Consequently, they are unable to refinance into an Option ARM loan to reduce their payments to something manageable and are stuck with a mortgage payment they cannot afford. They should have either, 1) not bought the home, 2) purchased a home they could afford (based on the 30-year fully amortized payment), or 3) waited until they 10-20% to put down.
Education. Loan officers and brokers have an obligation to educate their borrowers to help them minimize the chance of future problems. Borrowers, like many uninformed article writers, blame the Option ARM Loan when in fact they should blame their loan officer for not educating them. Certainly, loan officers and brokers in the business cannot be expected to know where interest rates are going, otherwise, they would be not be loan officers and brokers; they would be trading interest rate futures and making the big bucks!
Stated Income Loan. The big culprit in putting folks over their heads is not the loan programs, but the fact that borrowers can "state" their income to qualify. Although an Option ARM loan has a low payment over the initial few years, the borrower still must qualify as if they were going to pay the 30-year amortized payment. Because borrowers are allowed to "state" their income to the tune of often twice the income they actually make, they appear to be able to afford the amortized payment when in fact the amortized payment can be way more than they can comfortably afford.
Option ARM Loans can can be a valuable alternative to traditional financing if used properly and for the right reasons.
