Fixed Payment Option ARM a Recipe for Disaster

The tide of foreclosures has steadily been increasing throughout 2006. Since October of 2004 the prime rate has quadrupled. Loans made in 2004 saw their first reset to a higher rate. Soon to follow are loans made in 2005 and the second reset for loans made in 2003. If the prime rate remains steady the eye of the storm will be over us in 2008. Then it should get really interesting.

Two years ago a mortgage broker called to offer to refinance an investment property. The product was a “Fixed Payment, Option ARM”. There was no significant reduction on the initial payment after fees outweighed the benefit. When the product was explained I asked, “Do you think I’m crazy or stupid?” The payments for the mortgage described to me were fixed for 5 years. The interest rates would adjust to market rate and the difference added to the principal on the mortgage. After the 5th year, I would face a higher payment based on the reset, owe several thousand more on the house because of negative amortization from accumulated interest, and reduce the effective term of the adjustment from 30 to 25 years.

Most Option Arm’s reset automatically when the accumulated interest increases the principal 20 to 25 percent higher than the original loan. The reset payment is at a higher interest rate, against a principal amount 125 percent of the homes potential value, and paid within the years left on the term. An introductory teaser rate or fixed payment option will be worse. People and lenders are beginning to doubt the accuracy of their home’s appraisal. Low interest rates, runaway sales, and frequent refinancing contributed to higher prices. When these mortgages reset the loan could be more than twice the home’s actual value in some areas.