An article on the Pay Option Arm appeared on-line today at BusinessWeek Online and it sheds some light on this loan program. Pay Option Arms came into vogue in 2003 and 2004 when fixed interest rates started to increase but these loans were still offering low introductory or initial fixed rates. How? The Pay Option ARM uses what's called a lagging index, also known as a trailing index. For example, to determine the interest rate you would take the AVERAGE of the past 12 months of the COFI (Cost of Funds Index). So even if the COFI was starting to increase somewhat in step with 30 year fixed rates, the AVERAGE would bring the rate down today.
Mortgage Lenders like World Savings(recently acquired by Wachovia), IndyMac Bank and Downey Savings pushed the program through their wholesale sales force to loan officers and brokers. It's long been my opinion that very few loan officers know how these loans work so it is no suprise that borrowers often feel misled later on when the interest rate continues to increase.
I wrote an article on these programs titled "What is a Pay Option ARM?" which is posted on my blog at HomeLoanDFW.com. At the request of a reader and in response to a mortgage forum "war" held by a World Savings Wholesale Account Executive extolling the "greatness" of the Pay Option ARM, I wrote "Why you do NOT want a Pay Option Arm under most circumstances", which is published here.
The article on BusinessWeekOnline was very interesting because it included the performance and updated the current state of these loans.
"The bill is coming due. Many of the option ARMs taken out in 2004 and 2005 are resetting at much higher payment schedules -- often to the astonishment of people who thought the low installments were fixed for at least five years. And because home prices have leveled off, borrowers can't count on rising equity to bail them out. What's more, steep penalties prevent them from refinancing. The most diligent home buyers asked enough questions to know that option ARMs can be fraught with risk. But others, caught up in real estate mania, ignored or failed to appreciate the risk."
This is far from surprising. The start "teaser" rate on many of these loans was 1.00% and the COFI in October of 2003 was 2.408 compared to 4.502 today. That's a greater than 2% increase in 3 years. Think that's bad? Read on...
"There was plenty more going on behind the scenes they didn't know about, either: that their broker was paid more to sell option ARMs than other mortgages; that their lender is allowed to claim the full monthly payment as revenue on its books even when borrowers choose to pay much less; that the loan's interest rates and up-front fees might not have been set by their bank but rather by a hedge fund; and that they'll soon be confronted with the choice of coughing up higher payments or coughing up their home. The option ARM is "like the neutron bomb," says George McCarthy, a housing economist at New York's Ford Foundation. "It's going to kill all the people but leave the houses standing."
So basically, it benefitted the lender to put these loans on their books so they over-paid the broker or loan officer relative to other adjustable and fixed rate options. Being that I'm in Dallas which was recently reported as one of the top 3 markets for home foreclosure I hope these loans didn't gain much traction here. OH, and before you go thinking this loan program is just used in the coastal states like California or Florida...
"Through Mar. 31 of this year, at least 51% of mortgages in West Virginia and 26% in Wyoming were option ARMs."
YIKES! I haven't looked up the appreciation rate of West Virginia but that's one SCARY statistic. The real tragedy is in the underpayment of principal.
"Up to 80% of all option ARM borrowers make only the minimum payment each month, according to Fitch Ratings. The rest of the money gets added to the balance of the mortgage, a situation known as negative amortization. And once balances grow to a certain amount, the loans automatically reset at far higher payments. Most of these borrowers aren't paying down their loans; they're underpaying them up."
Now don't go thinking I gave you all the good parts of the article and there's no need to read the whole thing. That couldn't be farther from the truth. Please read it in its entirety.
©2006 Ken Stampe
Ken Stampe is a Mortgage Loan Originator, Mortgage Author and Mortgage Loan Officer Instructor living in Dallas, TX. Ken provided his first client a mortgage loan in 1996 and writes about home buying and mortgages to help clients make smart home mortgage loan decisions. Contact by email Ken@MortgageLoanDallas.com
What resource do SMART home buyers use?... Mortgage Calculator Bank.com