Homeowners cautioned to steer clear of option ARMs

July 24, 2005|By Eileen Ambrose

MORTGAGE LENDERS in recent years have come up with all sorts of strategies to finance home purchases as prices have soared: no-down-payment programs, piggyback loans and, most recently, interest-only loans.

But there's concern among consumer advocates and some mortgage experts about an even edgier type of loan that is rapidly gaining popularity, known as an option ARM. This adjustable-rate mortgage lets borrowers pick the method by which their monthly payments are calculated, including a "minimum payment" option where the loan balance actually grows.

"It's part of this whole mix of riskier mortgages that concern us," said Allen Fishbein, director of housing and credit policy for the Consumer Federation of America. "We think at least some portion of consumers that are turning to them are doing it out of desperation rather than financial planning."

Firm figures aren't available, but the Mortgage Bankers Association estimates that option ARMs may now account for up to 10 percent of mortgage loans.

Option ARMs, which also go by other names such as "pick-a-payment" or "cash-flow ARM," are complicated and the rules vary among lenders. Basically, borrowers can decide each month to make their payments under one of several methods. They can pay principal and interest based on a 15- or 30-year term. They can pay interest only. Or, they can make a minimum payment that isn't enough to cover the interest.

This last option - the most troubling - is also called "negative amortization." It works like this: The monthly payment is calculated as if the interest rate were 1 percent or so, even though the loan's rate may be 5 percent. Any unpaid interest is tacked onto the principal, and the balance grows.

"Every month, you owe more than you did in the first place," said Paul Havemann, vice president of HSH Associates, a provider of mortgage information based in New Jersey.

Generally, each year the monthly minimum payment can go up, often no more than 7.5 percent. So, a $1,000 monthly payment one year might increase to $1,075 the next.

Of course, at some point the principal and interest must be paid down. That's where payment shock comes in.

Borrowers often are required to immediately begin paying off principal and interest once their balance reaches 110 percent to 120 percent of the original loan. Even if that trigger isn't reached, payments usually are reset after five years so that borrowers pay off the outstanding balance over the remaining 25 years of the loan at the prevailing interest rate.

"If you project that interest rates spike in the next three or four years, which could happen sooner, as these loans hit their fifth year, a lot of people will get a very big bill," said Jack M. Guttentag, a professor of finance emeritus at the University of Pennsylvania's Wharton School.

Borrowers could see their payments at that time go up by 50 percent to 80 percent, he said. And these steeper payments will lead to more defaults and foreclosures, Guttentag predicted.

Whether that prediction proves true will be known in 2007, when the first wave of these five-year recalculations is expected to occur, experts said.

Many homeowners are betting that if payments get onerous, they can always sell their homes, Fishbein added. But if many people in the same area are in similar straits and putting their house on the market, prices can dampen and sellers could get a lot less than expected, Fishbein said.

Indeed, if home prices decline, homeowners looking to sell could find themselves owing more on the house than it's worth, especially if they put little money down.

"My general advice is to steer clear of [option ARMs]," said Guttentag, who runs a Web site devoted to mortgage information: www.mtgprofessor.com.

Indeed, these and other risky types of mortgages have caught the attention of regulators, whose job it is to maintain the safety and soundness of financial institutions.

Federal Reserve Chairman Alan Greenspan voiced concern last month about interest-only loans and other "relatively exotic forms of adjustable-rate mortgages." Federal banking regulators expect to issue guidance on these mortgages in the fall.

Maryland's regulators recently held a training session on exotic mortgages. And, though only a minority of state-chartered banks offer option ARMs and other nonstandard loans, such mortgages are now on the radar screens of state bank examiners, said Charles W. Turnbaugh, Maryland's commissioner of financial regulation.

Some lenders and mortgage brokers maintain that option ARMs aren't made to borrowers who can only afford to make the minimum payments. They say option ARMs are a useful tool in the right, sophisticated hands.

By choosing to make low monthly payments on a mortgage, homeowners free up cash that can be used to pay down credit-card debt and invest in their 401(k) or elsewhere, said Robert Walters, chief economist with Quicken Loans in Michigan, which is considering offering option ARMs.

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