Fixed Payment Option ARM is a Demented Product

A Barclays Financial report devoted to the impact of Option Arm estimates 48% of the loans will default when the mortgage payments reset or are recast. Mortgage payments are estimated to increase between 60 and 80%. I am not privy to their information, figures, and calculations but under today’s circumstances I feel Barclays report is very optimistic.

Fixed Payment Option ARM Recipe for Disaster first published here August 25, 2007 “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.”

The cold call I received from the mortgage broker described a mortgage with payments fixed below the prime interest rate for 5 years, with a calculated effective rate above prime. The effective rate had the potential of adjusting because it was still an ARM and the payments would remain fixed while the principal increased and the term decreased. It sounded bland and harmless on the surface.

After news of the Barclays Capital report I dug a little deeper and crunched numbers to calculate the following results:

$250,000 Mortgage

4% Fixed Interest-Only payment for 5 years of $833.00 per month (will not amortize)

Amortizing payment on a 30 year mortgage at 6% interest is $1,498.00 per month
Interest only 6% monthly payment $1,250.00

Using the Interest-Only difference between the payment the borrower is increasing their principal balance by $417 for every month they make the minimum fixed payment.

What was originally a $250,000 mortgage would have a principal balance of $250,417 after the first month’s payment. The effective interest rate (6%) will be charged the on the entire principal balance. If the borrower made the interest only fixed payment of $833 for 60 months, their balance (calculated at the effective rate of 6%) when the mortgage is recast at 5 years would be $284,245.00.
The principal balance would be 13.7% higher than the original mortgage, well below the adjustment parameters of 15 to 20 percent.

The mortgage payment is recast at 5 years or when the balance owed raises to 15 to 20% more than the original mortgage. It is then calculated to amortize fully within the original 30 year (360 months) contract. The problem is that the borrower now has only 25 years or 300 months to pay off a $284,245 mortgage.

The payment would jump nearly $1000 per month. The payment would rise from $833.00 to $1,831. To fully amortize the loan and pay off the balance within the allotted time the new payment would be $1831. Based on an effective rate of 6% that does not change for the life of the mortgage, I estimate the payment will increase by 120% instead of the 80% increase estimated by the Barclays Financial report.

Was the payment based on 4% in my calculations a teaser rate? After all it was based below prime. The effective rate in my calculations remained fixed at 6%, how many ARMs remain unchanged for 30 years? How many mortgages were created similar to the scenario I presented? What deranged mind came up with the product and the snake oil to package it and sell it to investors? I knew it was insanity 3 years ago. What took them so long?