Option Arms are in the news again
File this under: Unsuspecting borrower duped into getting a difficult loan to comprehend.
From Sunday’s Denver Post: Crushing ARMs squeeze homeowners
In 2003, 1.1 percent of mortgages originated for a purchase or refinance in Colorado were option-ARMs and another 2.5 percent were interest- only loans that didn’t pay down principal, according to First American LoanPerformance, a San Francisco mortgage research firm.
…
Many borrowers don’t understand amortization »”>negative amortization, how their payments are rising, and why the loans they expected to rescue them are dragging them into foreclosure, he said.
The mortgage brokers who sold these loans were (most of them are out of the industry) dumber than dirt yet were great at selling these products. If you went with a mortgage broker because they sold you on a loan products, who’s really to blame?
Study confirms Option Arms not evil
The study comes from NYU and Columbia, two universities known for academia not athletics:
according to a new study by professors from Columbia and New York universities, the “optimal” mortgage in a perfect world is precisely that kind of loan—an adjustable-rate mortgage with an option for amortization »”>negative amortization and a ban (or at least severe restriction) on prepayment.
Read the full article from Business Week
Mortgage Primer: loans that Wall St. doesn’t like
Here’s a mortgage primer on which loans are no longer the flavor of the month on Wall Street. They’re the Michael Vick’s of the mortgage world, they were once very popular on but now nobody wants to be associated with them. Okay, that’s a little bit too harsh since these loans didn’t kill dogs. Then again, these loans have put families in dire straits so lets keep the Michael Vick analogy.
Loans the Wall Street doesn’t like:
- THE LOANS WITH THE REALLY REALLY REALLY LOW RATE AND LOW MONTHLY PAYMENT
- THE LOANS FOR BORROWERS WITH REALLY REALLY REALLY BAD CREDIT HISTORIES
- THE LOANS FOR BORROWERS WHO HAVE GOOD CREDIT BUT WHOSE OVERALL LOAN APPLICATION DOESN’T MEET FANNIE MAE OR FREDDIE MAC’S STANDARDS
- THE LOANS FOR BORROWERS WHO CAN’T REALLY REALLY REALLY SHOW HOW MUCH MONEY THEY’VE MADE OR HOW MUCH THEY HAVE SAVED UP
- THE LOANS FOR BORROWERS WHO REALLY REALLY REALLY DON’T WANT TO PUT ANY MONEY DOWN
- THE LOANS FOR BORROWERS WHO REALLY REALLY REALLY DON’T WANT TO PAY AN AMORTIZED PAYMENT
- THE LOANS FOR BORROWERS WHO REALLY REALLY REALLY WANT TO BUY A HOME THEY HAVE NO INTENTION OF LIVING IN
- THE LOANS FOR BORROWERS WHO REALLY REALLY REALLY MAKE A LOT OF DOUGH
- THE LOANS FOR BORROWERS WHO REALLY REALLY REALLY HAVE NO INTENTION OF LIVING IN THEIR HOMES FOR 15 to 30 YEARS
- THE LOANS WITH REALLY REALLY REALLY NO RISK
Also called: 1%, amortization »”>NEGATIVE AMORTIZATION, NEG AM, OPTION ARMS, PAY OPTION ARMS or
“A CAN OF WHOOP ASS WAITING TO HAPPEN”
Also called: SUBPRIME, NON PRIME, POOR CREDIT, 2/28s, 3/27s, or
“I GUESS THIS IS WHAT I GET FOR NOT PAYING MY BILLS”
Also called: ALT-A or
“SO I’VE GOT GOOD CREDIT AND A GOOD JOB BUT I’M PENALIZED FOR NOT SAVING ANY MONEY”
Also called: STATED INCOME, STATEDSIVA, SISA, NO DOC, or
“DON’T THEY HAVE LOANS FOR PEOPLE WHO DON’T HAVE JOBS?”
Are called: 80/20, 100% Financing, NO MONEY DOWN, 103%, 107% or
“I WANT A LOAN WHERE I GET TO KEEP MY MONEY IN CASE MY JOB GETS OUTSOURCED TO INDIA”
Also called: INTEREST ONLY, IO, or
“IF I LIKE PAYING DOWN PRINCIPAL MY PAYMENT GETS RECAST TO A LOWER PAYMENT EVERY MONTH”
Also called: INVESTMENT PROPERTY LOANS, NON OWNER OCCUPANCY, NOO or
“I’M GOING TO BE THE NEXT DONALD TRUMP”
Also called: JUMBO, NON CONFORMING, SUPER JUMBO, MILLION DOLLAR LOANS, ANYTHING OVER $417,000 or
“THAT’S PRETTY LOW FOR A RATE OF RETURN AND PRETTY HIGH FOR A MORTGAGE INTEREST RATE”
It remains to be seen if Wall Street still likes:
Also called: ADJUSTABLE RATE MORTGAGES, ARMS, 3/1, 5/1, 7/1, 10/1, TEASER RATE LOANS, HYBRID LOANS, BALLOONS or
“THE AVERAGE PERSON MOVES EVERY 5 to 7 YEARS, SO WHY SHOULD I GET A LOAN FOR 30 YEARS?”
Wall Street will always like:
Also called: FHA, VA, CONFORMING, FANNIE MAE, FREDDIE MAC or
“THE LOANS THAT MAKE UP THE MAJORITY OF THE AMERICAN MORTGAGE LANDSCAPE”
Apathy and Ignorance
“Is it ignorance or apathy? Hey, I don’t know and I don’t care.” – Jimmy Buffet
Apathy: the trait of lacking enthusiasm for or interest in things generally
Ignorance: the lack of knowledge or education
According to a Bankrate survey 34% of homeowners don’t know the type of mortgage they have.
These were the key findings of the survey:
Homeowners:
- 36% who now have an Adjustable Rate Mortgage (ARM), plan to refinance to a fixed-rate loan when their ARM changes
- 28% of those surveyed worry either regularly or sometimes about how they will afford their payments next year
- 57% of homeowners polled have a fixed-rate mortgage
Your home is your biggest asset/liability depending on how you view your home. Most people either have one of three kinds of mortgages because there are only three kinds:
- fixed rate mortgage which means it’s fixed for 10, 15, 20, 30, 40, 45, or 50 years
- an adjustable rate mortgage which means it’s not fixed, it will adjust at some point
- a amortization »”>negative amortization mortgage which means if you don’t know what kind of mortgage you have then this loan is not for you
If you don’t know the mortgage interest rate and the mortgage loan program you’re in, simply find your mortgage documents and find your NOTE and read it!
The Feds explain high risk mortgages
Back in September, the Feds came out with a press release entitled: Federal financial regulatory agencies issue final guidance on nontraditional mortgage product risks–September 29, 2006. The purpose of this press release was to address the problems our nation has been having with high risk mortgages.
These products, referred to variously as “nontraditional,” “alternative,” or “exotic” mortgage loans (referred to below as nontraditional mortgage loans), include “interest-only” mortgages and “payment option” adjustable-rate mortgages. These products allow borrowers to exchange lower payments during an initial period for higher payments later.
These loans often carry the following layers of risk:
- Interest Only
- Adjustment of Rate
- amortization »”>Negative Amortization
- Prepayment penalties
: Interest only payments do not require principal reduction therefore your loan balance stays the same.
: When adjustable rate mortgages begin their adjustment phase, your loan payments may increase.
: When you only make the minimum payment your principal balance increases every month.
: If you decide to refinance or sell your home before the penalty expires, you may face severe monetary penalties.
For more on the Feds effort to explain high risk mortgages, check out these addendum’s which explain:
Phil’s take: I take pride in understanding these “high risk” mortgages inside and out. However, it took time to really understand all the nuances. On the other hand, a borrower has a month, maybe less, to really understand what they’re getting themselves into. The above documents are a good start but it won’t deter mortgage companies from coming up with even more complex loan programs in the future.
A letter from a reader
I get a lot of email. Some are linking requests. Some are spam that somehow get through GMAIL’s spam filter. Some are mortgage requests. Some are mortgage questions. Some are mortgage vendors trying to sell me something.
On Sunday, I received a well written argument from a reader who asked me to post his response to the Denver Post article NO MONEY DOWN: A HIGH RISK GAMBLE.
Phil,
I enjoy frequenting your blog, and wanted to be sure to share this with you. I am an independent Mortgage Broker with my own company Source Financial LLC, and I wrote an extended response to The Sunday Denver Post’s lead article from September 17, 2006 entitled “No Money Down: A High-Risk Gamble” [www.denverpost.com/ci_4347686].
I found the Denver Post article to be riddled with misrepresentations, one-sided accountings, and dangerous misinformation, all supporting a traditionalist approach to mortgages that has put two-thirds of all families into home ownership, but yet has led to a situation where the average fifty year-old American is worth negative $7000, only 5% of Americans retire at age 65 in financial dignity, and 9 out of 10 Americans die in debt.
In reference to my 2000 word response, Denver Post Business Editor Stephen Keating indicated that “I will take the time to read it and digest your observations, and discuss it with the rest of the reporting/editing team here.” Article author and Denver Post Business Writer Greg Grifffin wrote “This is a well-reasoned and well-supported argument. I don’t agree with everything you’ve said, but you’ve managed to get me thinking.” Unfortunately, checking today’s (September 24) Sunday Denver Post and www.denverpost.com, my response remained unpublished…
A Response to “No Money Down: A High-Risk Gamble” – The Sunday Denver Post, September 17, 2006 lead article [www.denverpost.com/ci_4347686]
As an independent Mortgage Broker that owns my own company, Source Financial LLC, in addition to being affiliated with a larger mortgage company that handles the processing and servicing of my loans, Lion Financial Corporation, I read the lead article “No Money Down: A High-Risk Gamble” with great interest. Knowing that a lot of folks along the Front Range turn to the Denver Post as an objective source for information, I was shocked and dismayed by much of the information and conclusions that were put forth on a topic that already invokes a fight or flight response among many home owners.
100% financing loans have been an amazing tool that has greatly contributed to the 5% increase over the last twenty years in percentage of homes occupied by the owner. But it is not the lack of equity that is putting these borrowers into jeopardy, it is a lack of a flexible asset base to deal with changes that has been increasing the risk of these folks defaulting. In general, people that utilize 100% financing for home purchases usually are lacking the liquid assets, emergency funds, and overall wiggle room to deal with financial hardship.
Of course lenders usually have guidelines concerning liquid asset reserves that must be held by the borrower in order to qualify for a loan, but often they only require enough to cover two to four months of mortgage payments. When people do face catastrophic events rightfully referenced by the Denver Post, “job loss, medical problems and divorce,” those reserves can often quickly disappear.
But having equity in one’s home when faced with these situations does not “give homeowners options when they face financial problems,” because it is precisely when folks are facing such dilemmas that they are quite often unable to qualify for refinancing, as at that point in time they are too high risk of a borrower for lenders to work with. As a Mortgage Broker I am deeply disturbed by this fact, but unfortunately it is a reality that we all must face when dealing with banks and lenders.
And probably the most misunderstood aspect of homeownership is the fact that equity is a ZERO PERCENT RETURN INVESTMENT. Yet two-thirds of Americans hold the majority of their wealth in home equity, which is a non-liquid asset that gives them absolutely zero return. Many people confuse appreciation, which is the increase in home value due to market trends, with getting some kind of return on their equity, but that is a common misconception. That is why it is so important for homeowners to separate their equity from their home via refinancing, and put those “cashed out” funds into investment vehicles that offer an actual rate of return. In doing so, homeowners increase their overall liquidity, improve their capacity to face emergencies, reduce their financial risk, increase their rate of return, improve their tax deductions, and diversify their investment portfolio.
Instead of spending their liquid asset base (savings) to finish their basement and send money to their parents, such as in the case of Jose Garcia and Maria Vanderhorst, borrowers with 100% financing have to exercise greater financial discipline. And putting money down and getting into a 30-year fixed would not have improved their situation, as then their down payment would be tied up as equity, which is a non-liquid asset, money that can only be accessed through refinancing or by selling their home.
100% finanacing loans are not dangerous, what is dangerous is borrowers not having a liquid asset base to deal with life’s contingencies. Unfortunately, these are the type of borrowers that tend towards 100% financing, as it really is their only option for home ownership. And tying up their wealth in the straightjacket known as equity is not part of the solution, it is part of the problem. An incredible means to access equity for the purpose of greater fiscal flexbility and all the other goods mentioned above, or “cashing out equity as one goes,” is the Option-ARM loan, which received quite a misguided slamming in the Denver Post article.
The Payment Option Loan gives the borrower four different payment options each and every month: they can make an Interest Only, 30-Year amortized, or 15-Year amortized payment based upon the fully indexed interest rate, or they can make the minimum payment that is based upon a very low “start rate” (usually between 1% and 4%), which involves deferring interest (a.k.a. negative amortization), or adding the difference between the Interest Only payment and the minimum payment onto the principal of the loan. Now while most lenders offer the Payment Option Loan with an adjustable fully indexed rate, one that starts adjusting as early as the first month, some lenders offer the Payment Option Loan with a fixed interest rate for the first five years.
The Payment Option Loan has proven to be a favorite of Real Estate Investors and Real Estate Agents, as it frees up extra cash flow on a monthly basis for much greater investment opportunities. Knowing that equity is a zero percent return investment is some powerful information to have.
The annecdote concerning Louis and India Harts conflated the fixed “start rate” with the adjustable “fully indexed rate”, such that readers were left with the impression that the Harts’ interest rate went from 2.6% to 8.1%. The start rate, which determines how much the minimum payment will be, is not a “teaser rate” that “quickly shoots up”. Some lenders do gradually increase the minimum payment itself (not its determining start rate) on an annual basis, usually somwhere in the range of 7.5% per year, to keep the borrower from deferring too much interest. But the start rates is always otherwise a fixed rate. It is the fully indexed rate, upon which the Interest Only, 30-Year amortized, or 15-Year amortized payments are based, that is adjustable is this case. And this fact is consistent with the numbers quoted in the article: the minimum payment of $919 the Harts are making would be the combination of $721 (2.6% start rate on a $180,000 loan) and $198 of escrowed Property Taxes and Hazard Insurance, which is approximately what they would be for such a home.
In the Harts’ particular case, they are going to have plenty of time to refinance before their loan starts to recast when the principal hits 115% (which would be $207,000 in their situation), as they will be well below that total when their three year prepayment penalty period is up. So the answer to Louis’ “I don’t know how we’re going to do it,” is that when those three years are up, they’ll refinance and get themselves into a loan that they feel more comfortable with and educated about. Though given their situation, if properly understood the Payment Option Loan really is their best option.
My question is how can mortgage products themselves be blamed for foreclosures? At best the article points towards a correlation, but demonstrating causation surely requires more than offhanded references to what some unnamed experts stated the next wave of defaults “may” come from. Beyond unpredictable catastrophic occurences like job loss and overwhelming medical bills, foreclosures occur because borrowers are getting into loans that they do not understand, and often they do not know that they do not understand the mortgage product. It is the responsibility of the Mortgage Broker to completely explain all the details of any mortgage product to the borrower. But it is also the responsibility of the borrower to be certain that they understand the terms of loan before signing off on it at closing. Vehicles and guns both kill in the range of 35,000 Americans each year, but it is the human misuse due to lack of education, ignorance or simple negligance that creates this reality, much like in the mortgage scenario.
Every different mortgage product serves its purpose, and what works for one borrower will not work for another given the specifics of their situation. To label certain categories of loans as “high-risk gambles” or as leaving “no room for slips” ignores the millions of families that are in these loans and find that they very much work for them. It is also a disservice to consumers to mislead them with such one-sided representations.
The true irony of the lead piece in September 17th Sunday Denver Post is that the conclusion that “Option-ARMs… could fuel a surge in foreclosures in the next few years” is the opposite of what we find is actually going on in the mortgage industry, as Payment Option Loans have proven to have the lowest foreclosure rate of any mortgage product currently on the market. World Savings is a bank that specializes in this product, which they refer to as the Pick-A-Pay Loan, as more than 90% of the loans they outfit borrowers with are of the Option-ARM variety. As a lender they have less than a 1% percent foreclosure rate! But World Savings, along with the independent Mortage Brokers like myself that they work with, take on the responsibility of educating the borrowers as to how to properly and smartly manage this incredibly powerful mortgage product.
A lot of mortgage brokers I know will not touch Payment Option loans, but I believe that is primarily because they are not all that interested in educating the consumer. Why not just throw them into a 30-year fixed APR mortgage? Everyone pretty much knows how that works. But that is also how banks make of the most money off of borrowers! The “list of higher-risk, alternative mortgages” the article refers to are not only not necessarily higher risk (Payment Option loan has the lowest risk, as discussed above), but they also provide the borrower the opportunity to increase their monthly cash flow by lowering their monthly mortgage payments by as much as 40%. In this way consumers are empowered to “become the bank” and grow their own investment portfolio, rather than falling into the trap of handing over their hard earned capital to the banks in the form of a large down payment or paying down principal so that they can have more of a zero percent return investment, equity.
Affiliates of Lion Financial Corporation, like myself through my company Source Financial LLC, do not shy away from the privilege or responsibility of educating our clients how to properly utilize alternative mortgage packages. And why is this? Because when families are taught smart mortgage product and equity management, they learn to utilize their mortgage as a financial tool for building wealth, which easily makes a $500,000 to $1,000,000 difference for the borrower over the next fifteen to twenty years. The affluent have always understood how to leverage their mortgage, pay as little down as possible, and keep very low monthly payments in order to increase cash flow for investment purposes. The American middle class is being transformed by engaging in these very same concepts and increasing their fiscal discipline, and I absolutely would not have it any other way.
Brent Ritzel
President/CEO, Source Financial LLC
Denver, Colorado, USA
An affiliate of Lion Financial Corporation
303-590-8999
Brent.Ritzel@lionfinance.com
The Option Arm Nightmare
Business week has an article entitled “How Toxic is Your Mortgage” which condemns the Option Arm loan program. The article explores the history of the option arm and the risk associated with a negative amortized loan.
For cash-strapped homeowners, it was a pitch they couldn’t refuse: Refinance your mortgage at a bargain rate and cut your payments in half. New home buyers, stretching to afford something in a super-heated market, didn’t even need to produce documentation, much less a downpayment.
Those who took the bait are in for a nasty surprise. While many Americans have started to worry about falling home prices, borrowers who jumped into so-called option ARM loans have another, more urgent problem: payments that are about to skyrocket.
Consider the following questions when evaluating this loan product:
- Do you understand the start or introductory rate?
- Do you understand the margin?
- Do you understand the index?
- Do you understand the effective rate?
- Do you understand the four payment options?
- Do you understand the minimum payment?
- Do you understand amortization »”>negative amortization?
- Do you understand the recast payment?
If you can answer all these questions, then maybe, just maybe, this loan is right for you!
1 Per Cent Mortgage Loan
Editors Note: Due to the mortgage crisis, 1% mortgage loans may no longer exist. Visit our home page if you’re in need of a mortgage loan in Denver.
Many mortgage lenders advertise loan programs with rates in the 1 per cent range. We also offer a full variety of these types of loan programs but borrowers must realize that the 1 per cent aspect can be a little misleading. All programs that you see advertised with 1, 2 or even 3 per cent rates these days are payment option programs. These are great programs for certain borrowers but are misunderstood by many.
Exercise caution when following up on advertising that boasts a loan with a 1 percent interest rate. These loans are not for everybody and they are some of the most misunderstood loans available. There are many newer mortgage professionals who are not even fully aware of exactly how these programs work, and they are selling you on the fact that you have a fixed rate and payment of 1% for 5 years. Your minimum payment will usually go up by 7.5% each year. This means that if you have a $1,000/month minimum payment, the next year this payment would go up to $1,075. Also, most likely this minimum payment is still resulting in amortization »”>negative amortization. The 1 percent rate that you are being advertised and told is fixed for 5 years is actually only the basis of your minimum payment required on the loan. Your actual interest rate on the loan will be your margin (which is normally anywhere from 2% up to 4%) plus your index (which can be LIBOR, MTA, COSI, etc…). Therefore, you would actually have a much higher interest rate on your loan than 1%. These types of mortgages will allow you the most flexibility in your monthly payments and can help maximize cash flow, however they are not a good mortgage choice for every borrower. This is one reason to make sure you have an honest, experienced mortgage broker to work with, for all of your mortgage financing.
As long as your mortgage professional explains clearly how your payment works you should be fine. Most people run into trouble with this type of program when it�s not properly explained. There is no way your principle will go down if your payment is based on a 1% rate when your balance is being charged a higher rate.
Often times rates advertised this low are nothing more than a teaser rate. It makes for a nice sign or ad but the fine print tells you that this is an intro rate. Most convert to a normal rate in 30-90 days. Your mortgage professional can explain these type programs to you.
Before you decide to enter into a negative amortization program make sure that your mortgage broker fully explains the program to you and how it works. This type of loan is very useful to some borrowers but is not for everyone.
When you pay an interest rate that is below market average, such as with a pay option loan, you have a negative amortization loan. Basically, you are paying a much higher interest rate, but your payments are based on the low interest rate. The difference in payment is added to you loan balance each month. If you make the minimum payment every month, your balance will increase, and you could end up owing more than your home is worth.
Amortization
Repayment of a mortgage loan through monthly installments of principal and interest; the monthly payment amount is based on a schedule that will allow you to own your home at the end of a specific time period (for example, 15 or 30 years)
Procedure of reducing a loan in equal sized installments, with principal and interest payments, versus interest-only payments.
Borrowers can make extra mortgage payments on their home loan to decrease the amortization term.
Generally, payments made during the first five to seven years of a mortgage go largely towards interest. As the loan matures, a higher and higher proportion of each payment goes towards the principal loan balance. These payment schedules, or amortization tables, can easily be calculated by yourself using just about any spreadsheet program out on the market.
Amortization can also be considered negative amortization if the monthly installments do not cover the total amount of interest payable during the month.
Other sites: Broker Outpost | Mortgage banker | What not to do after you apply for a Mortgage | Due-on-Sale-Clause | New Credit Card Minimum Payments| Pay Option Arm Calculator
Balloon Mortgage
A mortgage that typically offers low rates for an initial period of time (usually 5, 7, or 10) years; after that time period elapses, the balance is due or is refinanced by the borrower.
These can be ideal if you think you will be selling or refinancing your home in five to seven years and want a low monthly payment during that time. It would be prudent to make sure that you ask your loan officer that you will be able to refinance either before or at the time the balloon is due, and what conditions may apply. If you have concerns about meeting the refinance conditions or if you think the balloon term will be due prior to you being ready to refinance or move, then the balloon mortgage may not be your best option.
Balloon mortgages are most popular with 2nd mortgage notes, such as a 30 year amortized note due in 15 years (30/15). With the creation of the 40 year mortgage recently, 40 year notes due in 30 years has surfaced as a viable option for home owners on 1st mortgages.
The nice thing about balloon mortgages is that the large balloon payment due at the end of the loan’s term can either paid OR if you prefer not pay it, the balloon payment can be refinanced at that time into a very low monthly payment. This enables a savvy buyer to pay very low monthly payments for the term of the original loan and potentially even lower monthly payments after refinancing the balloon at the end.
Most commercial properties are financed with Balloon loans. Since Balloon loans are amortized over a longer period than they are due, they require lower monthly payments than their fully amortization counterparts. For income producing commercial property owners, loan programs with low monthly payments are most preferred.
Balloon mortgages are expressed in numerical terms such as a 30 due in 15 or a 20 due in 5, etc. The first number refers to the length of the amortization schedule and the “due in” refers to when the balloon balance becomes due.
A mortgage loan that mandates the outstanding principal balance be paid at a certain point in time. For example, a loan can be amortized as if it would be paid over 30 years, but it actually must be paid at the end of the tenth year.
Remember that lending criteria can change over time so that, in 7 years or whenever the balloon might be due, the criteria for refinancing might be more stringent, thereby making it more difficult for you to do the refi. Lenders offer lower rates for balloon loans because their risk is lower. Essentially, some of the risk is being transferred to you, the borrower in return for that lower rate.
Other sites: Broker Outpost | Due-on-Sale-Clause | Negative Amortization | New Credit Card Minimum Payments | Fixed-rate mortgage | Delinquency | Mortgage banker | Mortgage Broker vs. Your Local Bank| Pay Option Arm Calculator
Search
Custom Search