Today’s Wall Street Journal mentioned that Option ARMs are seeing rising defaults. It’s not hard to figure out how this could happen. According to the article, an Option ARM mortgage gave borrowers several options regarding their payment. They could pay only the interest portion of the loan, principal an interest, or a minimum payment that was often LESS than the interest portion of the mortgage.

Let’s look at an example to see how this might have looked on a $200,000 mortgage. Let’s say a couple obtains a $200,000 Option ARM at 6%. Their monthly payment would be $1,199 per month. Their first payment would be broken down as $1,000 going towards interest and $199 going towards principal. Here is a look at the first year’s payments:

Now lets look at what happens if this couple only pays the interest portion of their payment (assuming this is a 5-year option ARM):

As you can see, the mortgage balance is staying the same from month-to-month. Under a 5-year ARM, this would remain this way until the term expired. At that time, the borrower would then have to begin making principal and interest payments on the mortgage, which would mean that they would have to pay out a lot more money on a monthly basis.

So let’s see what happens if this couple pays a minimum payment of $800 per month, which is less than the monthly interest on the mortgage.

Choosing this payment method means that the mortgage balance grows from month-to-month. At the end of 12 payments, this couple would owe $2,000 more on their mortgage than they borrowed. It’s not hard to see how people could get into trouble.

So why were people even considering this kind of loan?

Well, if they thought housing prices were going to continue going up, they could always refinance into a new mortgage with lower payments. It doesn’t take a genius to figure out the risk in this line of thought. Imagine this couple above. What happens at the end of year one if the value of their house declines 15 percent? Assuming $200,000 was a fair price to begin with, their house would be worth $170,000 after a 15% decline in price.

You can’t refinance a $200,000 mortgage when your house is only worth $170,000!

Of course, the way around this is to accept the new higher payment and stay in the house until things rebound. Most people couldn’t afford to do that.

This is why we are in the fix that we are in right now. And I’m sorry but there’s NO BAILOUT IN THE WORLD that’s going to fix this mess. We have to let people who made these decisions reap the consequences of their decisions. The more we try to prop them up with bailout plans, the longer we stretch this thing out.