The reality of Option ARMs is bad enough that there is no need to inflate the amount of their payment at reset. It is not 5 x 10 times the current payment. Realistically is will be between 44% and 52% more then the current payment assuming interest rates between 5% and 6%.
I ran a quick analysis of an Option ARM minimum payment at the usual 1.25% "introductory rate". The introductory rate usually remains in place until the loan reaches 110% of it's original amount. Here is how it lays out;

Original loan amount:

$100K @ 1.25% interest $333.25/mo
30 year amortization

Paying only the minimum required payment, the loan will negatively amortize (add principal to it's balance) and hit it's "reset" amount @ 40 months in at $110K or 110% of the original loan. The borrower now has to start making principal and interest payments on the $110K amortized over the remaining 320 months.

This amount is $623.01 at 5% and $689.83 at 6%.

If the homeowner is able to refinance into a 30 year fixed mortgage their payment will go to $590.50 at 5% and $659.51 at 6%.

Herein lies the insidious problem with an Option ARM, the mortgage balance has increased and the value of the home has gone down, meaning the homeowner is either underwater or very close to it.

Most homeowners will be unsuccessfulin refinancing their home at 95% of it's present value with a 44% jump in their monthly payment.

I hope this makes sense.

I am the COO of a company that has developed a private, non-taxpayer funded solution to the mortgage default crisis and that can definitely help a homeowner faced with a resetting Option ARM remain in their home.

If you would like more information on our company please check our web site at [www.reidex.com] for a better explanation.

I bought a house in 1989, for 5,000 down (75,000 mortgage) at 10.5 % interest. And back then, no bank wanted to give me a loan. I had to beg for a mortgage!

Having lived through that, I know that the market fluctuates. These people who are taking out loans that are too good to be true need a wake up call. If you SIGN YOUR NAME for something, read all the fine print.

Doesn't anyone know what a signature means anymore?

And, to be fair, what precisely do any of your examples have to do with financial common sense?

I handle employment and wage verifications where I work. Over the last few months, I've seen several mortgage applications from employees who make $13-$14 an hour. Because of my position, I know a bit about their personal situations other than wages, and I just don't understand how these companies would even consider loaning these kids $200,000 (which is the average cost of a house in our area). The 8k tax credit is part of the bait, I'm sure, to convince these kids that they can afford the "American Dream".

It makes me ill.

I keep in touch with a high school friend who now works on Wall Street, and he just bought his second Maserati (he keeps it at the house in Connecticut). Of course he gets to reap the rewards of short-term profits, while the very decisions he's making have huge long-term liabilities he will not have to pay for. I suppose we're all stupid for not taking the same job.

There are plenty of us who have good jobs, decent but not great credit, and have been trying to take advantage of the market to finally buy a house. Nobody is creating mortgages unless you have AAA platinum rated credit. And I'm not seeing the fire sale on property that we should be seeing, even in areas with 20%+ empty homes and 50% plus empty condos (we had a big building boom during the good years, and now that all the luxury condos have been finished, all the people who had put deposits down in 2007 are saying "no, thanks!").

The banks would rather just go back to Uncle Sam for another bailout, or let property sit vacant, rather than sell the property for what it is actually worth in the current market.

@RvLeshrac:

Oh, and for the record? I chose option A. People still tell me that I'm an idiot for renting and not buying a home using one of those ridiculous loan packages.

Fortunately, unlike the average american, I posess critical thinking skills.

@JimBoSlobish:

Pretend you're the average American - you know, the one that doesn't believe in evolution and can't even name the state capitols. Say you want a home, and go to a realtor, who sets up a meeting with a financial advisor at the bank. This is the spiel you get from them (combined, as a space-saver):

"We can give you a million dollar home for $250,000 and only charge you $300 a month for your mortgage payments. But only today, and only if you sign up for an ARM. If you sign up for a traditional mortgage, you'll have to pay $1500/mo for the same house."

Now, these are two people you trust. One of them is supposedly an expert in finance, and the other is supposedly an expert in real estate. You don't have the extra income to pay for a personal financial advisor. What do you do? Do you:

a) Continue to rent a home/apartment, despite everyone around you telling you what an idiot you are for renting and how owning a home is very affordable.

b) Jump on what looks like an incredible opportunity to buy a very nice home that, according to everyone, is going to continue to increase in value for years to come.

@Trai_Dep:

And people wonder why politicians talk in absolutes and worst-case scenarios.

Just goes to show that if you can't say anything in absolutes, don't say it to Fox.

These loans payed out HUGE commissions to Loan Officers and Brokers. So they pushed them on a lot of people especially in rapidly increasing markets like CA and AZ.

They were also so complicated that even the few honest people selling them often did not really know how they worked. They were unable to explain the loan mechanics to their clients- even if they wanted to- and the rarely wanted to.

To make it worse: since the minimum payment (bellow the interest only payment and therefor Negative Amortizing) did not change they often sold these loans as "Fixed Rate." In reality, only the payment was fixed and even that was only fixed for a period of time.

Oh, and for a little extra pain- the almost all have "hard" prepayment penalties. Which meant you were going to pay up to 6 months interest if you refinanced the loan or sold your home and closed the loan within a certain amount of time (from 6 months to 3 years).

In short- probably the worst loan idea ever.

I just can't imagine why anyone would get any adjustable rate loan when interest rates where near historic lows.

Why are these even legal? Seriously.

I know some responsibility goes to a homeowner for signing up, but why would we allow a bank to do this?

No, we must save the poor, poor financial companies like GM and Bear Stearns who were forced by those evil, evil homeowners into signing contracts with ridiculous clauses like "if the homeowner doesn't pay, the bank gets the house" as if the bank would really want a house. No, we must make sure that our tax money goes straight to those who need it most, those poor banks who thought they could take liars at their word and were taken advantage of.

But they get the house too. It's in the contract, after all.

When I was looking to buy about 2 years ago, I saw commercials for $500K mortgages at $400 a month. I thought it was strange because I can afford $400 a month, but I know I can't afford a $500K house. When I looked at it, not even the allure of buying a $500K house could make me sign up for such a loan, and I'm not usually a rational person with such things.

Part of the reason the payments go up so much, is that you weren't paying the real payment anyway. You may have been paying 50% of the actual payment, now you need to pay 200% of the actual payment, so it ends up being 4 to 5 times what you were paying, not what you should have been paying. (figures completely made up)

Still, not all ARMS are bad news. Our standard 5-1 ARM just rest last month and the interest rate actually went *down* -- from 5% to 4.25%.

Yes, because they're shaped like breasts.

First of all, a 10-15% increase in the principal should not cause a 5x or 10x increase in the payment. Perhaps the introductory rate is expiring at the same time?

Exactly. So the new payment is based on a real interest of 6.5% (for example) instead of the 1.5% ARM teaser rate they had before. And the payment is also recalculated based on the now inflated principle due at the same time.

Second, I've always heard these loans referred to as negative amortization loans. I'd heard the Option ARM thing but thought it was something different.

That's my understanding as well, but I believe many (perhaps all?) Option ARMs are Neg-Am

[www.calculatedriskblog.com]

[www.calculatedriskblog.com]

Apparently Option ARMs are even more complicated than that. Frankly, I think Neg-Am loans should be illegal. They already are in several States

@tailstoo:

The most troubling thing about the financial crisis is our collective retreat into extremist, oversimplified arguments. Economic systems and goverments don't just oscillate wildly between poles, and neither should citizens.

there's really no good reason to take an option-arm that i can think of. maybe if you were expecting your salary to increase greatly within the 5 years, but that doesn't seem like a very responsible way to borrow huge sums of money.

I'm tired of being responsible, not spending more than I can afford, and not jumping on the "get rich quick" schemes that melt down. Isn't this supposed to be a free market? If it's not, then let us know so we can all embrace socialism.

Anyone that took an Option-ARM loan deserves to loose their house. They are the people that have brought all of this on us. And yes, I know it's still the banks fault too.

This has already been priced in. The graph in reference has been around for years, and banks are way ahead of this issue in terms of loan-loss reserves. This will be dealt with in a similar manner to the credit card default crisis from earlier this year, which rose and fell without much incident. The next wave isn't residential real estate, it's commercial real estate, and that's going to take down literally hundreds of local banks.

unless you mean a second helping at the trough for bankers. in that case, yeah, i'm sure that will be their answer.

It won't until the labor market is healthy again, AND housing is near its inflation-adjusted long-term average (something like 150k for the nationwide median). So, another 10 to 20 percent drop assuming unemployment (bullshit measure or not) is back down by then.

The only basis I have for saying this is that it has happened again and again.

Hindsight being what it is, it's a safe bet that many of these people with option-ARM's were looking to cash in after a couple of years - before the mortgages reset. You know, sell for a nice $100k bet since we all know the value of houses only goes up. Whoops!

It means the banks are going to find more new ways to piss everyone off.

Usually you get four options to pay - one is the same as if the loan was a 30 year, fixed at the current adjustable rate, one a 15 year, one pays just the interest, and one pays less than the interest. As the expert said "it was a great loan product for real estate agents." If you make good commissions one month, you make the 30 year payment, if very good commissions, pay the 15 year. If you have low commissions, take the heat off for a few months and pay the less-than-interest payment. The problem with these loans is that no one, at least on the regular consumer level, pays more than the less-than-interest payment.

@dilbert69: ARM loans are a type of NegAm loan, but NegAm is not limited to only interest rate increases.

It just goes to show how traditional financial companies don't give a rats ass about the people that keep them in business.

@teh: It's the opportunity to buy a house you normally shouldn't/wouldn't be able to afford for payments well within your range. I'm not sure if everyone that signed up for these realized how short term the smaller payments would be, but if the terms weren't fully presented to or understood by an unsavvy consumer really itching to buy, I can see why they'd take the bait. I think a lot of people also just thought they'd be able to get some equity in the house and refinance or sell for profit before the terms changed.

Interest only loans are almost just as stupid. Your payments won't adjust, but good luck selling in a down market.

...and some think housing is ready to rebound. LOL!!!

Nothing to worry about, Helicopter Ben and Turbo Tax Timmy can just throw more money at the problem. When in debt make more debt.