Option ARM Loans - If You Have One You Need to Read This
October 24th, 2007 Categories: Buying a Home, Mortgage and Finance, Real Estate Tips
I’ll have to say that in all my years of selling homes in the Raleigh area, I do not remember any client using an Option ARM to finance their purchase here locally. I guess I must deal with a more conservative group of home buyers. So what is an Option ARM and what should you do if you have one?
The “what is it” part of that question is more difficult to answer than the “what should you do if you have one” part. Let’s talk about what it is first. It is a very creative loan product that allows the borrower to choose from multiple payment options including an option to pay zero principle and only a portion of the interest. This payment option, called negative amortization, actually allows the loan balance to increase as payments are made. Sounds a bit scary to the more financially conservative among us, doesn’t it?
No need to discuss any of the other payment “options” because they are all totally boring, like paying interest AND principle which will reduce your loan balance. So why in the world would someone want to choose a loan payment option that results in increasing the balance owed? The obvious answer is to have a lower monthly payment. How much lower? I’ve seen examples where the payment could be cut in half! How would you like to only pay $1,200 for your $2,400 mortgage? Tempting, huh?
This might make sense if you were in a market where the value of the home is increasing at a much greater rate than the negative amortization is increasing your loan balance. If that scenario is sustainable, and you plan to sell the home in a few years, I guess you could come out ahead in terms of cash flow. The problem is this idea of the value of the home increasing is not sustainable. Just ask some of my clients in California and Florida.
According to an article in the Wall Street Journal, Countrywide is about to face yet another crisis; this time it involves Option ARM loans. The best estimates are that the default rate has more than doubled for these types of loans which made up $93 billion, or 19% of their volume for the year 2005. Keep in mind that these borrowers were not classified as subprime.
What should you do if you have one of these loans? If you live in an area where your home has not decreased in value, refinancing might be a pretty good choice. You see, the value of your home is important even if you do not plan to sell. If you need to refinance, and your home has decreased in value while the loan balance has stayed the same or actually increased, you might not be able to qualify for the new loan.
If you want the name of a good lender to talk to about your situation, give me a call and I will connect you with someone who is trustworthy.
Always remember, especially when it comes to financing something as large as a home purchase, if it sounds too good to be true, it usually is. And also remember you simply cannot detach the financing process from the home buying process and expect to get the best possible results. Every single one of my consultations with home buyers in the Raleigh area includes a thorough analysis of financing options with one of my lending partners. Finding your dream home and messing up the financing can quickly turn your dream into a nightmare. Get all the facts, look at all your options, and seek wise counsel.
Bob-Another great article here. I am a lender and I have seen very few people in OUR market utilize this product. You briefly alluded to Florida and California and the rapid appreciation properties there experienced. Those two markets were a HUGE source of Option ARM originations. This CAN be an excellent product for the DISCIPLINED borrower that takes the savings on payment and invests that difference somewhere else. The goal here is to get a greater return on the investment than the interest that is accruing on the back end of your loan. That way, you have a lump sum of money to pay off this interest at a later date and you have made additional monies on your investment. Many people use this to grow their wealth.
Many people chose this product for a different reason. Many borrowers chose this product for a different reason. They live in the areas that WERE rapidly appreciating and saw this product as an opportunity to afford the home of their dreams. The market was booming and everyone was feeling good. Mr. and Mrs. borrower felt that they could finally afford their dream home and the market would support their loan choice.
Hindsight is 20/20 and we now see that this was not a good choice for the folks that wanted to use this to just afford a home.
As with any investment choice, there are risks involved. Always remember to speak with a mortgage professional to assist you in your investment choice. The CHEAPEST payment is NOT always the best choice. A true mortgage professional will review your current as well as future financial goals and tailor a program to help you achieve them.
Bob - I have seen people really find themselves spinning out of control with these types of home loans - great article - hope it helps others skip it all together and the rest run to refinance. - Cyndee Haydon
Hi Bob - I think you did a great job in pointing out the complications with these types of loans. This loan product is not necessarily any better or worse than others, it is just more complex. Hopefully, anyone who took out an Option ARM had a loan officer that educated them about the loan and about negative amortization. Sophisticated borrowers can find this type of loan advantageous as can people who may have flucuations in their income due to self-employment or commission based work. All-in-all, these types of loans simply require a knowledgeable mortgage professional, as does any other type of mortgage decision. Thanks! Andy Holloman, 919-459-1316
[...] Bob created an interesting post today on Option ARM Loans - If You Have One You Need to Read This.Here’s a short outline:According to an article in the Wall Street Journal, Countrywide is about to face yet another crisis; this time it involves Option ARM loans. The best estimates are that the default rate has more than doubled for these types of loans … [...]
Thanks for the comments guys! As a Realtor I feel it’s my duty to advise and counsel about the entire home buying process, of which the mortgage is an important part. Option ARMs is one area where it looks like we all agree. They have their place for savvy buyers who can get better returns on their money, but should never be used by our clients to buy a home they otherwise could not afford.