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Broken ARM? Should've watched your Step...

By
Real Estate Technology with BoomTown

There has been quite a bit of material written about the sinister mortgage programs called Option ARM's, or fixed payment mortgages. Dangerous, Predatory, Deceptive, ______ fill in the blank with your "watch out!" comment of choice. The general consensus on how these programs hurt borrowers is getting to be a little much and beginning to bother me.

Option ARM's (and other fixed payment mortgages) are fantastic if implemented correctly. There is plenty of literature out there on how Option ARM's work, calculators, the negative amortization ability etc.

For this post, we shall concentrate solely on the Interest Only (IO) Payment Option for this class of loans, since this is where the magic happens or all goes to hell in a handbasket.   Pop a Ritalin and pay attention, then go back and read it again...it's not an easy read but well worth the extra time.  First off:

Never, ever, finance a property with an Option ARM, based solely on the Minimum Payment Option as the means to affording the home.
 

OK, on with the show... 

Payment Option 2, The Interest Only Payment.

The Interest Only (IO) payment is determined by adding an Index (I) to a Margin (M) to yield a Fully Indexed Interest Rate (FIR), or I% + M% = FIR%, or 4% + 2.5% = 6.5%. Never mind what the literal definition of Index and Margin are for now, just understand that the I and the base M are set by the lender according to borrower specific criteria (credit score, property use, LTV, etc).

The Fully Indexed Rate is the rate to be concerned with.

Why? This is the interest rate that determines how much interest you can negatively amortize (if you make the Minimum Payment) and represents what the loan is truly costing compared to other types of mortgages.

BEWARE!!! The base Margin can be adjusted by the Broker to generate excess YSP for their unjust enrichment. For Example:

The Program uses the MTA Index, which is (hypothetically) 4.2%.

The borrower qualifies for a 2.5% Margin.

This yields a 6.7% FIR (4.2% + 2.5% = 6.7%), BUT

The Lender pays YSP to the broker/banker if the Margin is increased above par (in this case 2.5%) , so if the Broker bumps up the M to 3.5% (from the par margin of 2.5%), the FIR now equals 7.7% (4.2% + 3.5% = 7.7%). The broker would get paid a few thousand bucks (depending on the loan amount) to do so.

This is where borrowers can get in trouble if they don't pay close attention. Brokers will sell clients on the low Minimum Payment while 'silently' increasing the margin to yield a monthly interest deferment equal to another small mortgage.

Generally, Option (and other fixed payment) ARM's are best suited for:

  • Those who can understand and explain the nuances outlined above.
  • Property with excess equity (20%+ preferred)
  • Loan Amounts above $200k.
  • NOO/investment property, where the Minimum Payment is used to generate more cash-flow, or during times of vacancy to minimize the monthly liability
  • Locations with appreciation anomaly factors (Coastal/Waterfront, new development, etc)

The name of the game when dealing with exotic mortgage programs is education. Ask the mortgage professional what the base Margin is compared to the margin you are being 'quoted'. Ask more questions, even ask ME...if it still doesn't make sense, the program is probably not for you.

Comments (16)

Allan Pape
Austin, TX

"Never, ever, finance a property with an Option ARM, based solely on the Minimum Payment Option as the means to affording the home."

I completely agree!!!

Oct 26, 2006 07:35 AM
Derek and Mariana Wagner
The Artisan Group- Keller Williams Premier Realty - Colorado Springs, CO
The Artisan Group - Colorado Springs REALTORS®
Great post. Thank you. I completely agree. I didnt even know that there were loans out there that qualified off the first year... awful.
Oct 26, 2006 08:02 AM
Marc Blasi
Palm Beach Gardens, FL

When and if I ever get a Customer this type of loan ever again I'm going to go through the entire explanation and then ask the Customer to explain it BACK to me to see what they really do understand.

 There are situations where this type of loan is a good choice - as you mentioned above- but too often people come to me with "I want that 1% thing I just heard about" - and they don't have a CLUE.

Oct 26, 2006 08:06 AM
Robert D. Ashby
Cruise Planners of South Florida - Plantation, FL
Providing Personalized Travel

Great post.  I am glad to see that others like to educate people on the pros and cons of these types. 

I wrote about the abuse of these and other types of loans and why they are getting a bad reputation.  I should have picked a better title, but here it is...

http://activerain.com/blogsview/16215/Exotic-Loans-Being-Mistreated

Personally, I like to see all of my clients qualify based on a 30 year fixed, then utilize whatever program is best incorporated into their financial plan to achieve their financial goals and dreams.

I know of several scenarios where the Option ARM is a great benefit beyond those you listed, but the key is they are not for everyone and the pros and cons need to be weighed upon prior to implementation. 

If anyone wants to know more information about these loans and the scenarios they can be used for, they can contact me as well.  I only do mortgages in Florida, but I am willing to assist when I can elsewhere.

Oct 26, 2006 08:23 AM
Jeff Corbett
BoomTown - Charleston, SC

"Personally, I like to see all of my clients qualify based on a 30 year fixed, then utilize whatever program is best incorporated into their financial plan to achieve their financial goals and dreams."

Outstanding strategy Robert.... 

Oct 26, 2006 08:43 AM
Jeff Belonger
Social Media - Infinity Home Mortgage Company, Inc - Cherry Hill, NJ
The FHA Expert - FHA Loans - FHA mortgages - USDA loans - VA Loans

Good post. But Derek & Mariana..... maybe you read something differently in this post. I don't think he said these programs qualify you at the first year rate. At least not on a Pay Option Arm. Sure....on an interest only loan. Just thought I would mention this.

Oct 26, 2006 03:17 PM
Michael Roberts
Real Estate Professionals of Glynn - Saint Simons Island, GA
As a Realtor I have a bit of an issue trying to act as a financial advisor and therefore I do not.  I do educate a buyer if they ask.  I also utilize reputable lenders who I have dealt with for a number of years, who have demonstrated a solid product knowledge and an awareness of individual client needs as opposed to meeting their own business objectives.  If a client chooses to utilize a nonrecommended lender and we do discuss their financing and when I hear something questionable.  I prob with additional questions attempting to get the client to become more informed and capable of making a better informed decision.  But in no way am I going to offer specific product recommendations or choices.  I am but a mear professional not their keeper, trainer, father or mother. I am just the guy who they came to for professional input.  It is up to them to accept or reject it.
Oct 27, 2006 01:12 AM
Gabriel Silverstein
Angelic Real Estate, LLC - New York, NY
SIOR

This is a good note of caution for the uninformed.  For our personal real esate invesment financing I always make our mortgage broker break down where the money's going, including their fees (yes, like us brokers, if they don't get paid there's not much point in their being in business, so expect them to make some real money on a deal).  Our broker also acts as a warehousing agent, so but for some knowledge of their yield spread premiums and a little pushing for disclosure, it would otherwise be invisible as their customer. 

For clients that ask how to figure out what their mortgage broker is making, tell them first to ask the mortgage broker and then note that so long as their mortgage broker does not act as a warehousing agent, they should see the fee their mortgage broker gets on the HUD-1 settlement/closing statement. 

For those that aren't familiar with the term, as a warehousing agent a broker actually issues the loan themselves, with an already in-place committment from the ultimate lender to buy it from them for a pre-negotiated price based on the lending terms.  The term is derived from the fact that the broker holds the loan themselves very briefly.  The difference between the settlement proceeds provided at the close by the loan to the borrower, plus any costs the broker covers at closing, is the yield spread premium and commission they get.  For some of them, this is their only fee, for others this is separate and in addition to another disclosed and visible sourcing and placement fee. 

Caveat Emptor still holds.  With the number of web-based lending institutions out there now (e-loan, Lending Tree, etc.) any internet literate consumer should investigate what more than one option tells them their rates and costs should be.  This is possible to do based on providing their credit score (at least on e-loan) and other information, without actually having their credit checked by multiple potential lenders, which is detrimental to their credit scores, to the tune of three points on each bureau's score for every credit check.

While I won't hand out financial advisory advice, I agree (with Michael Roberts' post), but I do think that as a trusted professional with knowledge of situations surrounding our industry, those that effect our clients, anyone who does not do thier best to at least warn a client to do some additional homework before choosing an exotic lending product is only asking for their client base to be lost to foreclosure and inability to buy another (larger) home in the future.

Oct 27, 2006 03:12 AM
Jason Sardi
Auto & Home & Life Insurance throughout North Carolina - Charlotte, NC
Your Agent for Life
Very informative!  I hope this was made available to consumers as well.
Oct 27, 2006 03:19 AM
Ken Cook
Content, coding, marketing, host. - Marietta, GA
Content Marketer/Creator

Jeff, now THIS is a good post. 

I'll just reference: These older postings of mine.

If you're a borrower and you're reading this you BETTER educate yourself on INDEXES (indices for the rest of us). The index that Jeff cites - the MTA is the 12 Month Treasury Average but it follows the 1 Year Constant Maturity Treasury Rate. There was a report last month that said, "Beware: The 12MTA is still increasing while the CMT is decreasing." I laughed my hiney off! This just shows why reading an article or blog from someone with no mortgage banking or financial experience is a laugh. If the CMT is decreasing today then the MTA is decreasing tomorrow. Don't be a stupid borrower: KNOW WHAT YOU ARE GETTING!

This is one of the most powerful tools for wealth management the mortgage industry has ever produced but be honest with yourself. Read the postings I cited above and be realistic: If you can't handle this loan don't get it because may well end in disaster. 

Oct 27, 2006 03:25 AM
Robert D. Ashby
Cruise Planners of South Florida - Plantation, FL
Providing Personalized Travel

When looking at indexes, as is being highlighted throughout, you must remember that indexes that are an "average" of another index or security, such as the MTA mentioned above, are like being on a roller coaster.

The index or security the average is tied to is the front car, while the average of it is the last car.  If rates are going up, you went to be in the last car.  But if rates are going down, then you want to be in the first car.

The MTA as described above is based off the 1 Year CMT.
LIBOR is another index used in ARM products as well as the CMT itself.  There are a multitude of options to "tie your ARM" to.  Many of these can be gauged as to the direction they are headed.

What does that mean to you?  Do your homeowrk and "tie" your ARM to the vehicle you think will be best suited for you when your ARM starts to adjust.  For instance, you may want to focus on a LIBOR index if you are in a 3/1 or 5/1 since the Fed may lower interest rates by then and LIBOR is closely tied to what the Fed does here.  This would mean, you would be in the front car that is heading down.

As Ken mentioned, ARMs (all of them) when properly integrated into your financial plan can provide wonderful wealth management benefits.  Seek the guidance of a true professional and develop a mortgage plan.  Then watch your money grow (over time).

Oct 27, 2006 03:58 AM
Scott Gormley
Oak Valley Mortgage-California Home Loans and Refinancing - Chico, CA

Good post Jeff...

I see loan officers that don't explain these loans well to clients and they are setting the client up for trouble. If you clearly explain the benefits and setbacks of an Option Arm to a client, then you have done your job and the decision is theirs. I tend to do these on low ltv's for investors that are increasing the cash flow of their rentals and using the descrepency for high yield investments. The goal, use the NEG AM to your advantage, not your demise!

Scott

Oct 27, 2006 04:19 AM
Jeff Corbett
BoomTown - Charleston, SC

 

 

My understanding is that under the relatively recent FICO algorithm changes, the bureaus allow up to 6 credit pulls within the mortgage industry over 60 days at no penalty, to accommodate a consumer’s right to 'shop'.  Mortgage lenders fall under a specific class of credit providers, separate from credit card vendors, auto loans, or installment (bank) loans et.al. so the bureaus don't indiscriminately penalize like they used to.  I will attempt to locate and reference the hard copy content for all to review...   

 

 

Oct 27, 2006 06:37 AM
Robert D. Ashby
Cruise Planners of South Florida - Plantation, FL
Providing Personalized Travel

This is the wording regarding credit pulls and the effects on scoring...(FTC website)

Auto- and Mortgage-related inquiries that occur 30 days prior to scoring have no effect on the score.  Outside this 30-day period, auto- and mortgage-related inquiries that occur within any 14-day period are treated as one inquiry.

What does this mean.  You can have your credit pulled by as many lenders as you want within 14 days of the original credit pull and they will all count as one.  Beyond that, the first pull (and the subsequent remaining) do not even have an effect on your score until 30 days after the first credit pull.  This is to encourage "shopping" without fear of destroying your credit.

That is also why, and you mortgage brokers know this happens, if the lender pulls your credit just prior to closing and is over 30 days from the original credit report, the borrower's score has dropped.  This may lead to the borrower no longer qualifying for the loan program or losing the rate and fees agreed upon originally.

Knowledge is key!

Oct 27, 2006 08:26 AM
Jeff Corbett
BoomTown - Charleston, SC
Thanks Robert!
Oct 27, 2006 09:14 AM
Robert D. Ashby
Cruise Planners of South Florida - Plantation, FL
Providing Personalized Travel
No problem.  Happy to help.
Oct 27, 2006 11:15 AM