How An Option ARM Could Bite You in the Rear

January 30, 2009

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.

12 responses to How An Option ARM Could Bite You in the Rear

  1. I was just thinking today that it has been a while since anyone here in the comments talked about what a great idea it is to borrow a lot on their mortgage, pay it off slowly, and invest the difference in S&P 500 index funds.

  2. Sam,

    Yeah, yeah…

    I still think over the LONG run it’s a good plan as long as the numbers are right. With mortgage interest rates as low as they are, I think it makes a lot of sense to borrow long and invest. That doesn’t mean that there won’t be times when the strategy doesn’t work.

  3. I’m beginning to think they should offer these mortgages as a test. Then anyone who opts for the third (lower payments then minimum) should be automatically disqualified for a mortgage. And a big DUMMY statement appended to their credit report for a years time.

  4. Angie,

    The original target population for the Option ARM’s (as explained to me by my mortgage broker) was for commissioned employees. This way if they had a low earning month they had an option to pay less than the interest under the assumption that they would pay extra during high earning months.

    Of course barring that anyone who chooses option three more than a couple of months in a row should get the “Dummy” stamp.

  5. The original target population may have been commisioned employees, but for whatever the reasons may have been the option ARM was marketed to average individuals. I even saw on one of the news programs how a woman put down $40,000 on a $128,000 home and was given an option ARM. Clearly, this is more than the 20% required for a normal fixed rate mortgage.

  6. Call me cruel, but I really don’t feel for those who are defaulting on ARMS loans or any other mortgage. Barring unemployment (and tragedies), I feel no remorse for those who bought too much house or got into a payment they can’t afford. Not everyone in this world is cut out to be a homeowner.

  7. Sam – I think it’s a great idea to pay the mortgage off slowly, and invest the difference in S&P index funds. Especially now, when interest rates are extremely low, and the S&P is cheap.


  8. Option ARMs have been around for decades. They were originally targeted at wealthier borrowers who understood leverage and have the ability to pay down their mortgage in large chunks.

    Some genius figured out that they could market the loans to Joe Six Pack by focusing on the minimum payment option. It is no surprise that about 95% of the people with option ARMs only make the minimum payment. Most consumers are payment focused. Of course, lenders like Kuntrywide and Wamu pushed them on the masses along with encouraging some boiler room mortgage broker shops by paying exorbitant commissions on the loans.

    There isn’t a bailout around that is going to fix the option arm problem. These people can’t afford their McMansions under ANY SCENARIO. They need to be foreclosed on and go back to renting.

  9. I live in Northern California. California appears to have been “ground zero” for option-ARMs (“pick-a-pay loans” as they were called by World Savings). Until about a year ago, the radio ads for such loans were overwhelming, even though both the real estate and credit markets were tanking. Sadly, too many folks believed what they wanted to hear, and failed to read even a summary of what they were getting into. Lawyers are NOT customarily involved in residential real estate closings in California, so there was little “adult supervision” involved in these transactions. The interviews of the folks now in default now make the six-o-clock news once a week. Uniformly, they all claim fraud. More uniformly, they all seem like folks who never should have tried to buy a house in the first place (or re-finance, with a cash-out, as the case might be). No amount of bailout will ever make these folks able to pay anything near what they owe. Sadly, this pig will just have to make its way through the python.

    Just my $.02


  10. I live in Northern California, too. I own a home, have an Option ARM that I understand and love, I was originally a subprime first-time mortgage borrower, had little funds to purchase my home (100% loan!), OK-to-bad credit, BUT I am also a hard-working, determined, educated, and actively thinking individual who believes in working for your goals, and making them happen by being responsible and learning from your mistakes, not repeating them or having someone hold your hand while you boo-hoo.

    We all make choices everyday about the big and small stuff, and then we must live by them.

    I agree with both Bozo and Thomas about not having much sympathy. I am a regular full-time worker, but I am also a licensed Realtor and Loan Officer. I can’t tell you the number of times that I explained –in kindergarten language — the way an option ARM works to borrowers, and they acknowledged to understand at the time. I was neither arrogant nor condescending in some high-falutin’ expectation that they should claim to understand even if they didn’t. And I would offer further examples or scenarios just to make sure, especially if I didn’t quite see the ‘mental click’ in their empty stare back at me. Then later, when they weren’t gaining 20% annual profit, or able to flip their houses (which they did NOT originally purchase as an investment property BTW)in 6 months, or able to tap out every last dime in another refi less than a year later, they would call me up once again wanting to refi into a better loan or to help them because the payments were too high or would be too high the very next month. Again, BEFORE they agreed to get the Option ARM — or any other subprime or similar loan altogether –I went over year by year how their payment would increase, would tell them about the deferred interest being tacked on to the current loan balance and how the bank would use THAT balance to calculate next month’s payment, showed the 7.5% annual increase in actual dollars since percentages are hard to see unless you translate into money, etc. In other words, the whole nine yards of disclosure and due diligence in terms they could/should understand if they know how to tie their shoes, drive, and make breakfast, and certainly if they are ready to take on the job of being homeowners and repaying a debt. STILL, when luck worked against them or their own mismanagement or overestimation of being able to handle a debt kicked them in the rear, they went crying to me or to others that they had a ‘bad loan’ or look at what “their loan was doing.” As if they never had a clue…If you multiply this situation of “voluntary ignorance” (normal people simply NOT paying attention as they should to straightforward information being provided to them) by the hundreds of thousands of new and first-time homeowners, and factor in the high probability that not all mortgage brokers were as honest and explicatory as I was…well, we’ve got our stew.

    The easy fix since long ago would have been for banks to simply work with their clients to do what is now commonly heard of: the loan modification. The banks should have skipped over the requirement for the current property value (the appraisal) to come in at or higher than the current debt, and simply refi the borrower into a manageable amount that would also continue to make them a profit. If the banks had not simply shut the door on people after their own, very wide latitude and blind eyes to so many predatory and strategically directed marketing practices approved the loans in the first place!…they could have avoided everything that came next.

    Instead the toxic combo of banks’ greed for money and profits, and the average consumer’s (forgive me) state of ongoing ignorance and failure to do anything about it, has produced one of the biggest financial fiascos of our time. See what happens when you let the “free market” do as it will and let the ingenuity and pioneering of so many private financial wizards make up the rules?! They are finally doing what they should have done long ago (only the process is uglier now), and the individuals who must lose their homes, will. Those homes will be re-sold to truly capable buyers who can re-pay the debt, and the market will eventually go up again. This is the story and up/down wave of human history, as well as of financial markets. Don’t worry, just invest now, keep up your mortgage payment, and buy a property right now if you’re able to, because the market for buyers is terrific right now. Low rates, low values, and genuinely verified borrower capacity to re-pay. What more do we want? Let the renters rent and the buyers buy! In b/w we should all take the lesson here and educate ourselves more on this and any other important subject in our lives that is lacking! That reminds me, I have to find out how to run electricity to one of my rooms through the attic.

    Take care all, and hope my comments help instead of hurt. It’s the only way I meant them: to shed light, not cast more shadows. Yes, it’s a tense topic, but I only hope our country heals and GROWS from this experience. I am no Marxist, but capitalism in its free-flowing randomness and “entrepreneurship” does a great job of ignoring the very human and likely qualities of greed, corruption, and unethical behavor just to get your piece of the American pie. Shame on us, and let’s do a better job this time around, individuals as well as institutions. Thanks for reading my long schpeel!

  11. I don’t understand all your negativity on ARM.
    With Interest-only mortgage,do pay extra $$$ towards the principal, reduce monthly i-o payments,keep adding-up to the principal and you’re on the fast truck to a cash-cow(w/investment property).Ha-ha.

  12. Although there are numerous reasons as to why an Option Arm loan would be quite harmful for certain individuals, there are some people who would greatly benefit from this type of loan, based on the following: declining interest rates & payments, can be self-modified, and is especially helpful for the smart investor.

    The full article can be read here: