Michael,

You can't say a blank statement like that. I do agree that most people who went with this loan where misinformed.  However if your true rate is in the 8 or higher how much YSP did you get?  I think you have to understand what loan really is meant for.

1. Self employed people who need to manager cash flow

2. Jumbo's or super Jumbo's

3. Financially educated people

4. People who need some payment relief and understand that they are using the equity in the house.

Neg am is not a 4 letter word but someone who is finacially savy and want to take advantage of some tax benefits they can.  (at the end of the year they can stroke a check for the neg am)

Hi Matt:

I'm sorry but I still have to disagree.  Yes I'm here to make money as well.  Although I prefer to make my money in the most ethical way possible.  That means I present my borrower with several options and show them the end result/net worth in 3, 5, 10...30 years time.  I do this for any borrower that comes to me saying that some other lender was trying to sell them into an Option ARM.  In my experience, it makes a lot more sense for a borrower to cash out equity at 6.25% and use the money they cashed out to help them make the payment until their income is at a level where they can afford the payment.  So to your point, even the most financially savvy buyers would steer away from the Option ARM.  Otherwise, they're kidding themselves.

Michael I agree if the person income was stable.  This was designed for self-employed people whose income goes up and down.  It can give them the ability to pay more one month and less another.  It is a tool.  and as for your rate I have lenders who I can do this loan as a 5 year arm (true rate locked) and have a 2% min pay for the 5 years with a rate under 7.   To have an option costs money. 

As far as financially savvy I  have a huge list of CPA's and clients in jumbo's and super jumbo's who would have to disagree when it comes to putting them in a much better tax situation at the end of the year.

I do agree this is not a loan for everyone.  Unfortunately to many L/O's looked for the easy money and never told the people the whole picture of this loan.

Matt I would agree with you if interest rates on the Option ARM were identical to Conforming, but they are not.  I can still structure a deal that'll give my borrower a lower interest rate relative to the Option ARM.  Thus allowing them to achieve a higher net worth in the long run.

Having said that, I'd like to have your "huge" list of CPA's so that I could call them and let them know I have a better program for them.  :-)

Thanks for your comments by the way.  I think its important for consumers to see both sides of the discussion.

Michael I agree with you when it comes to Conforming rates.  The one thing I honestly can tell you if anyone puts a client in these type of loans with a high LTV like 90-100...That is just so wrong.  The only way I could see that is if the purchase price is well below the appraised price.. but even then.... But I don't know of any lenders now doing it at 100%.  I still have some doing it at 95%.

I completely agree.  My company, the #1 lender in the US, doesn't even offer them, and that is for good reason.  An interest-only loan is the perfect option for people with unstable income...however, if they can't afford the interest-only payment, they can't afford the home.  We shouldn't be putting people in these types of loans if they would ever have to use the neg-am option.  I just don't see how it could be used as a positive program.  It's used because there is huuuge YSP to be made...and most is made by not fully disclosing all aspects of the product to the customer.  With full disclosure, the product is just not a good one...and that's the only way it should be sold.

Chad I do agree that the client should always have full discloure and knowledge of how the program works.  But last I checked we are not GOD's so all we can do is inform the clients and give them choices.  We don't make choices for them. 

Personally I love the Option Arm. It does provide me flexiability, I understand the benefits and realize if I truly save any of the difference and put that into an interest account that is generating more then the interest I am paying then I will have a much greater return. However, if I decide to go out and shop away the savings plus have the deferred interest then who is to blame, my loan broker.  I think not.

I know the loan brokers I refer speak often with their clients to remind them of the true benefits of this loan. 

The subprime loans started the disaster. The option arm is going to absolutely destroy everything left standing. Bad loan! 

Great topic Michael - I am shocked this blog has not recieved more hits. I am going to put this link in a few of my blogs. The 1% loans are going to be the big topic on the news in the next few months......  LP

Ok, I have to add a nother comment.

It is not the loan, it is the fact that people are approved for the loan when they have no business getting it. Great example, why would a lender approve a first time buyer with a fico of 670, no mortgage history, buying a home 3x their current rent and only putting down 5%. This is the problem! 

Great loan, add some restrictions it can only be used for 720 fico, good debt ratio, mortgage history, LTV, etc.

I agree with Kelly 1000%... until the last couple of weeks you could do that loan at 100%.. that is just crazy...The only one that loans benefits is the loan officer.   They need just to tighten the underwriting.

Thanks Lewis I appreciate the link!

Kelly thanks for clarifying your comments.  I agree that the underwriting guidelines need to be changed.  However I still believe there are better options even in your own case.  If I were able to write loans in California I'd be calling to go over your financial portfolio with you now.  :-)

You got it Kelly!  Great comment!  - Lewis Poretz

Very good post Michael and I agree with you regarding this loan product.  I've never sold it and if I would ever consider it would be if it would help the client who again should be financially saavy, able to benefit from it and know the complete ins and out of the program.  Frankly, I'd still would steer them away from it!  The interest-only is definitely a better choice, but I also think that this program needs to be explain thoroughly to the customer so they understand how it works and the ramifications of just making the interest only payments for a long period of time.  Buyers need to be educated to combat the misleading advertisements that bombard them on a daily basis.

Good post and insight, Michael!

I wanted to thank everyone for commenting on this topic.  I've been talking to a lot of people about this topic since I posted my blog.  I still believe this loan is not a good product for the consumer in 99.9% of the cases.  However, one person convinced me that if used in a short term investment the Option ARM might be something to consider if the short term investment return is much higher than the interest rate.   Again I would not recommend it all, however if a real estate investor came into my office and said he/she wanted the Option ARM, knew the ramifications of it, and said its only a temporary solution; I would first take a look at the other loan scenarios to at least show them which option gives them the higher net worth in the short and long term.  99 times out of 100 its always a loan product other than the Option ARM.

With that being said, I still believe it's a bad product for the typical borrower buying the home they plan to live in.  If a borrower is considering buying a home where they cannot afford the payments on a conforming loan, than they shouldn't be buying it.  Keep in mind everytime someone defaults on a loan this has an effect on the market.  We're seeing it now in the Subprime markets and with PMI rates increasing.   People were able to buy homes they couldn't afford in the past and now we're seeing the fallout from that today.

WOW.  Many different thoughts about Option ARM's.  I would say that they are not evil and that they are good loans for some people.  In our business you need to look at all the different options that would best fit the client.  As a LO you must be honest and talk about the good and bad of every loan.

The one comment I find wrong is the one that is strips people of wealth.  I in fact would submit when done right it builds a persons wealth by having an option ARM. 

Here as a LO when you ask for assets to qualify for the loan do you look at the assets in the home.  Can they qualify for the 3 to 6 mos of liquid cash a person would need to qualify for loans? 

When done right. an Option ARM can help people become more wealthy and keep their home if a problem would arise. 

On that note.  I would never take a 100% CLTV out on a home like this.  I think 80% is good.  You say the person would lose money every year.  This is true if they blow the money.  People need to learn how to make money work for them. 

I like talking about the different loans out there.  I think to many people get placed in loan because they had a LO place them in a product with out really knowing what the client really needed. 

This is a bad sign..and we see the downfall of that now. 

Dave, my point is that if a customer can qualify for a lower interest rate on a conforming loan, 95% of the time they are better off refinancing some cash out rather than choosing a Pay Option ARM product, because their interest rate will likely be 2% less!  The Laws of Finance still hold true and therefore Net Worth is always negatively affected when the borrower can choose a normal conforming loan over the pay option ARM.

So that's what all those pesky telemarketers really when they leave messages saying "you are pre-qualified for as low as a 1% intrest rate on yur home" Somehow I did know it was too good to be true - how do they get away with it????

Debbie you guessed it!  They get away with it, because many borrowers don't read the fine print.  During the closing process the Index and Market rates are spelled out for the borrower in the documents they sign.  How many closing have you been to where the borrower reads and understands every single document they are signing?

Some of my My clients use these loans to get into homes now that they would not otherwise be able to afford.  They seem to be informed as to the negative amortization consequences of choosing the least expensive option.

Hi Laura.  Thanks for your comments.  I would love an opportunity to speak with your clients about their current debt structure, because in the current market the negative amortization is even more painful when considering the fact that homes prices have fallen and the poor market conditions.  So if they're only making the minimum payment they're not only losing equity because of the debt structure they have, but also because the market prices are not going up currently.

Great post and comments.  I have a bit of a different take.  Our company is the national leader in non-owner occupied transactions.  Most of our clients/investors use a hybrid option ARM, they have to have a FICO over 700 and they have to be 80/20 LTV.  We also make sure they have enough reserves to cover several months of no rentors.  The markets we put our clients in are all appreciating at 7 - 10% and higher so the deferred interest does not eliminate their equity.  AThe reality is most of our investors are re-financeing at 3 years to leverage into another property and then 1031 exchange at 5 years into two others.  With this strategy the hybrid option ARM works great and is a great tool for people to build their wealth. It also offers people who want to invest but can't handle a negative cash flow a way to get in the game with out being negative cash flow.  By the way, we have done over 1,500 transactions over the past 4 years and not one of our clients has gone into foreclosure or had any trouble as a result of these loans. 

I agree that it should only be used by specific people in specific situations and is not right for the avg. typical customer.  Just my two cents. 

Hi Doug.  Thanks for your comments.  This could work out to be a nice strategy for investors in high appreciating markets.  Unfortunately, we don't have those markets in the Chicago area right now.  However, if we did I would still recommend my borrowers towards conventional interest only as long as the overall interest rates are better than the Option ARM. 

Michael, your dead right, it has to be a high appreciating market to make sense.  That's how the program has received a bad name.  The wrong market at the wrong time for the wrong customer. 

I have to confess, I'm not a loan officer.  I'm part of a team (business developement) and a dedicated loan officer is assigned to me.  I know she has used different programs in different markets at different times for various reasons.  A big part of what she recommends and why has to do with what the investor is trying or needs to accomplish. 

I'm new to the real estate world and some of the horror stories I've heard about what some unscrupulous lenders have done is amazing.  And it seems as if they're able to get away with it by simply saying "you signed the papers".  The "pre-payment" penalty is still one I'm trying to get my head around. 

Good post, can be viewed and commented on from many angels.

Thanks again Doug.  Right now, the option Arm is not a good product for most markets considering how high the index rates are as well.

An additional negative:  for most of the Pay Option ARMs, once the negative amortization reaches a set threshold (usually 110% or 115% of the original amount borrowed) the loan automatically converts to a fully amortizing loan.

For many people, this means their payment will increase substantially.  As they have used up most of their equity through negative amortization, they cannot refinance.  A devastating situation.

This is one of the reasons that I have never sold this loan and, most likely, never will.

Thanks Steven.  I agree with you.  For the vast majority of borrowers this is a terrible product, regardless of whether they understand the consequences of the loan or not.  Even the most educated borrowers can find themselves in the very scenario you describe.  Thanks again.

The problem with the Option ARM is that irresponsible "loan officers" have pushed this product on people who don't understand the concept of negative amortization. 

Whenever I have received a phone call from a mortgage company soliciting the "1% loan," I have asked them how this loan works. Nobody could answer the question.

The product has been sold incorrectly, and irresponsibly. There are a select few times when the Option ARM is a great product for a borrower, however the mortgage professional needs to explain all of its risks. 

Several factors which need to be explained are:

• The Index (LIBOR, MTA, COFI)
• The Margin
  
• Pre-payment Penalty
• Recast period (110% or 115%)
• When the client will reach their "Freedom Point"
• What will the client do with the additional cash flow by choosing the minimum payment option?

It's all about responsibility. We need to take charge and educate borrowers so that these other criminals don't continue to give our profession a bad reputation.

Galel Fajardo

Coast Mortgage Group 

Thanks for your comments Galel.  I completely agree with you.

How about the borrower who gets a lower salary throught the year and then receives a huge bonus at the end of the year? They could use the bonus to pay down the negative amortization and yet keep their payments sustainable throught the year?

How about the avid real estate investor who is rehabbing and fliiping. 3- 6 months of negative amortization is worth it for them if it means they can handle three projects at one time.

I do not believe that anyone is fighting you on the fact that the loan is misrepresented to many borrowers by LOs who want to make 3.5 in YSP and slam them with a PrePay. Or that people are enticed to take the loan and it is simply not explained well enough, however, Loan Originators who are good at what they do, understand the loan, the correct way to explain it, as well as the right borrower for the loan.

Do not forget, we are the professionals. We are the ones people pay for our professional advice and opinion to their unique situation.

I have to put my two cents in.  I think option arms are a great financing tool for the right person and right situation.  I have clients that ask me about option arms and once I start explaining the way the loan works if they don't get it I take them in a different direction.  The person with great 35% back end ratios, money in the bank, steady, full time jobs probably would not benefit from this loan.  But people who are self employed (myself included), need cash flow now or financing jumbos or super jumbos this loan works.  If your not comfortable selling it then don't.  If you'd like to learn more but don't feel like your reps are educated enough look up World Savings ( I hate that fact that I am plugging them and no one else) but they are a very conservative lender and their loans do not recast because of the way they are structured.  Another reason for option arms is in the hands of a savy borrower they can actually recast down at the determined time instead of recasting up.  Which would lower the interest rate and payment....

Hi Leo and Marie.  Thanks for your comments.  You are correct there are certain types of individuals that may like this loan.  However, I'm speaking to the masses here, and I feel that this is a poor product for the majority of home buyers. 

Michael  - You are very right it is not the right loan for the majority of the home buyers out there, but for a small few it can be the right fit I think.  I believe we are agreeing on this??? :-)

I think the Option ARM is a great product for anyone who is financially disciplined to invest the difference.  The biggest challenge with these loans is that we as loan officers have no way to determine if clients will continue to invest the money systematically and responsibly. 

The Option ARM is hands down the best financial leverage tool that I know of in a strong real estate market.

There are actually Option ARM's with rates as low as .250%, not just the 1% and 2% loans mentioned here.

For real estate investors looking for short term gains (holding less than say 5 years), this is a great loan, provided that the real estate market is strong, and appreciation is high. 

In my area, many homes appreciated 20 - 30% last year and the year before.  For someone to be able to buy a $500,000 house for $500 per month and then sell it 2 years later for $725,000 and write off the $60,000 in negative amortization this is a great loan.  Now with appreciation of say 7%, it's not as attractive, but you can see where this loan could be a great tool for investors.

This product works for very few people and only in very strong markets. Who can predict with certainty how long a market will stay strong? It's a big gamble.

The biggest gamble is not the loan, it is whether or not a borrower has a discipline to make the loan work to their advantage.  It's not a big gamble if you know where to invest the money that you would otherwise be paying to principal.  It's easy to find guaranteed returns that are higher than mortgage interest rates. 

If you're borrowing at 7% and investing at 8.5%, then where's the risk?

Homeowners in general need to realize that the equity in their homes is not a good investment.  It's not. The rate of return on equity in a home is 0% (possibly even less than 0%, because you have to maintain the house at an expense).  If the value of homes go down, you lose equity, there's nothing the individual homeowner can do to maintain their equity when the market goes down.

So, why not separate out some of the equity and have a more diversified overall investment mix?

Hi Marie.  Yes there are a select few individuals that might find this loan useful.

David.  I would agree with you if I thought the "overall" interest rates on Option ARMS were lower than convential loans, but they just aren't.   You're preaching about the "teaser" rate of .25%...which I think is exactly the wrong message to talk to people about.   It takes advantage of the misinformed individual and compromises your integrity in my personal opinion.

I agree with you on separating your equity from your home.  However, I don't think anyone should put themselves in an Option ARM to do that when the rates are so much higher.  Most individuals can get into a convential loan or interest only loan and accomplish the same thing. 

Why are you so closed minded and keep thinking that giving your money away so the banks can put it to work and benefit from it is better than putting your money to work for you. This kind of thinking is what keeps Americans trapped in the old way of thinking that traditional 30year fixed interest loans are the best.

Great post, I wrote an article a while ago suggesting the same thing. Borrower education would at least explain the pro's and cons that the loan officer is glazing over in search of a higher commission. Originator education would make sure that anyone who wanted to sell an option ARM is properly prepared because I think a large part of the problem is that some of the loan officers don't fully understand the way the loan works. It should be illegal, or at least mor heavily regulated especially in the current mortgage turmoil. I mean, it's not a bad option IF the borrower has shown a history of saving and applying extra money to pay down a mortgage principal. But if the borrower is solely using it as a means of lowering a payment and the loan officer is according with that view than it's a lethal situation. Maybe you should have to get a special designation in order to be able to sell option ARM's, something to do with financial planning or taxes.

The thing that people don't understand about an option ARM is that if you are paying a 7.5% interest rate fully amortized and you count on an average return in a medium volitility account of 14%, then you are making 6.5%, you then subtract the inflation (averaging 3.5% per year) so you are at 3%. Then take your tax bracket out of that, which most people who will see any benefit are at about 40% total (state and federal) which only winds up giving you a 1.8% return. This however does not take into account rising rates or changes in index.

Manny I don't believe I'm closed minded, but I do feel that I have a responsibility to explain all of the drawbacks of this program.  This loan program is an even worse option today, than when I originally wrote this blog.  Today, when house prices are declining, and index rates are high this is a terrible loan program.  The bottom line is that unscrupulous loan officers/brokers like to sell this loan, because they can make more "easy" and "big" money on this loan program.

Jeff thanks for the comments.  Some states are putting in their own regulations to "protect" consumers from these types of loans like in Illinois.  I have serious questions as to who the state legislature in Illinois is trying to protect though.  Unfortunately, the regulations in Illinois are set up to protect the federally chartered banks and thus giving them an unfair advantage over state chartered banks and mortgage brokers in the types of loans each can sell. 

Thanks for the thanks Michael. I have to agree with you. I posted on the evils of the option ARM just to ask questions and spark conversation here http://activerain.com/blogsview/199915/Option-ARM-s-the . My big this is that the option ARM is not allowing us to recover from the low we are in. I mean mortgage fraud isn't helping as well as other things, but the equity stripping and defaulting from option ARM's are pushing things over the edge. I am VERY glad that the states are doing something about it.

Hey Michael!
Just "crawling" and found your post. While I agree that pay options are not for everyone I have and will continue(as long as I can find investors to fund, Wachovia) pay options but only if the clients eyes are wide open to the mortgage. I use it as a "bandaid" mortgage (when folks have bought a new home and have not sold the first one) or an "investor" mortgage. I also want to be sure that the client has enough assets to get them out of it (if needed)

Yes, the loans have gotten completely out of control due to brokers not understanding them and the others trying to get a quick buck

Happy Selling!
Tony Grego -Indiana Mortgage Broker

Michael,

Good past, it is creating interaction. That's always good. But I think you have missed the mark on the problem.

It not the product that is bad. The real problem is that greedy or inexperienced originators use the program incorrectly. It the originators abusing the product that are bad. It is the investor that let's the originator abuse the product. Far to many loan officers put borrowers into this loan because the YSP was the best of the available programs that the borrower could qualify for.

Your negative amortization and loss of net worth statements are shock value conclusions.    

The only hold true if the loan officer abuses the program and the borrower. 

I think your 0.1% estimate of people that the loan is good for is so under the percentage. It's more like 5% to 8% at a minimum.

If a borrower lives off of a base income and gets big bonuses or commission check 1 to 5 times a year this is a good loan - they make several principal payments a year. This keeps them out of neg am and net worth issues and they have more cash flow during the periods that they are living on their base.

There area number of scenarios that this product would be a good solution for that is just one of them. 

Question.. Are you a consumer advocate (like Clark Howard) or are you a loan officer. I don't think you can effectively be both. But that another post.

Hi Lee,

Thanks for the response.  I appreciate the comments, even though I disagree with some of your assessments.  First, I think the problem started when banks figured out that there was a higher risk market available on the secondary market.  This in turn caused banks to start offering products like the Neg Am option arm.  Which in turn also caused a lot of greedy and inexperienced originators to start selling these products because the YSPs were so good.  So I think we're in agreement there!

However, I don't agree that 1 in 20 borrowers or possibly more (you quoted 5-8%) are a good fit for this product.  In fact, I believe its a very rare occurence, unless your an investor on a short term deal or your looking for a short term cash crunch solution.  Beyond that I don't see any benefits especially when fully indexed rates are higher than fixed rates.

To answer your question.  I am a consumer advocate.  I used to be a loan officer at one time, but now I concentrate my efforts towards helping people understand loan products.

I could not agree more.  It takes a very savvy borrower to truly understand the Option Arm.  I for one have made it an illegal option for me.  I will not originate an Option ARM for anyone.  If a customer is insistant on getting one I send them to one of my competitors.  I don't need the headaches later on.

Somehow, I TOLD YOU SO, just doesn't say it all for me.  What types of loans would you think caused our current mortgage crisis...Loans where hard working folks who put 10 or 20% down on the 30 year fixed loan, or loans like the now extinct Option ARM?  Oh my people are sure silent now, aren't they?

All of my clients always make sure that the loan I am selling them is not an ARM.  I don't think ARMS are a bad thing, people just don't understand them completely.

Greg,

This is about the OPTION ARM, not a regular ARM.  I don't have a problem with standard ARM loans, as long as clients understand that they'll need to refi or potentially pay a higher interest rate at some point in time.

The OPTION ARM on the other hand, is a horrible product that was designed to make lenders a lot of money, without any regard for the client.  As a result, these loans trapped buyers in bad situations.  Foreclosures are much higher on a % basis on the OPTION ARM loan than any other loan.  Good luck trying to find a bank that will even do an Option ARM anymore.  So again, I TOLD YOU SO just doesn't quite say it all for me.