In defense of Option ARM mortgages – Not! :: SoundBiteBlog.com

Ditech and Quicken Loans are doing a great job of enticing people with thoughts of $600 a month payments for $200,000 homes. Just remember what your mother told you years ago. “If it sounds to good to be true, it probably is.”

I detest Option ARMs! In my opinion, they are nothing more than the legalized pillaging of American home equity. Lenders with enormous advertising budgets promote them in a fashion similar to old-fashioned used car salesmen. They hook consumers with thoughts of low payments for expensive homes. Or, low payments on refinance transactions. The disclaimers on the television would make an eagle squint. And they are gone faster than the fastest speed reader can read. Of course when a consumer calls on the advertisement, he or she is connected with a salesperson. Salespeople are not well known for watching over a client’s best interest.

If you have seen or heard these adveritisements and wondered about them, you probably have more questions than answers. Let me pull back the curtain and show you how these loans work. First though, I’ll tell you that an Option ARM can be a valuable loan instrument under the right circumstances. You must understand how they work before you take the plunge into them. And that is the problem! Most people with Option ARMs do not fully understand how they work. These are the people who end up in my office or on my telephone, terribly concerned because something is not right about their loan. They don’t know what it is, exactly. But they know something is amiss. 

Disecting the words

Options are good in most situations. We all like options. I don’t like to be told what color pants I have to wear or what food to eat. I like options. The Option part of an Option ARM refers to the payment. A borrower typically has four options:

• Minimum Payment
• Interest Only Payment
• 15-year Payment
• 30-year Payment 

The minimum payment is very low and is the payment in the adverising. It does not cover the interest charges for that month! So if a borrower makes the nice minimum payment, they will have a larger mortgage at the end of the month than they did at the beginning of the month.

The Interest Only Payment is exactly what it sounds like. The payment will equal whatever the interest charge it for the month. So the loan stays the same from the beginning to the end of a month. It doesn’t get any higher and it doesn’t get any lower. You are just treading water.

The 15-year payment is an estimate of what it will take to pay the principal balance off in 15 years. But, it’s just an estimate. This is an ARM, remember? An Adjustable Rate Mortgage. Nobody has a crystal ball for interest rates, so the lender cannot tell you exactly what you final interest rate is going to be. You just have to cross your fingers and wait. A borrower can easily make 15 years worth of payments and find out it was not enough.

The 30-year payment is an estimate of what it will take to pay the principal balance off in 30 years. But, it’s just an estimate. Just like the 15-year payment. Nobody knows exactly what is going to happen to rates over the next 30 years. The lender can only guess.

As you can see, none of these four options gives you any kind of stability. The interest rate changes almost right away, and it can change every month. The payment can change throughout the entire loan term. A borrower is completely at the mercy of the market.

The Bait

Now that you understand the lingo, I’ll explain how these work.The original payment is calculated on the Starting Interest Rate. This is usually 1% or 1.25% or something similar. Of course when we use an interest rate this low, we get a very low payment. This is the bait in the advertisement. Consumers become focused on the low payment and salespeople keep them focused on the low payment. If the consumer spots the fact that the minimum payment is not enough to pay the interest for the month, the salesman guides the consumer to the Interest Only Option.

The Sting

Most Option ARM mortgages are only fixed for the first 30 days! The interest rate often jumps from the introductory rate of 1% to 7% or higher at the beginning of the second month. Now do you understand why I detest these loans? If an Option ARM is properly explained to the average consumer, very few will choose them. They are very volatile and therefore financially dangerous. Most of us do not like danger. We work hard for our money and dislike anything that puts ou money at risk. These mortgages are not being explained properly to consumers. The low intruductory rate is pointed out, the low starting payment is pointed out and the payment options are highlighted with phrasing like “choose your own payment each month” or “make the payment you think you should, not what a bank tells you to”. The fine details, such as the fact that each month the bank owns more of the house than they month before, are glossed over.

Does an Option ARM mortgage ever make sense? Yes, sometimes they do. In each situation, they are a very good short term solution to a short term problem. Option ARMs – Playing with dynamite intelligently is an article that will post tomorrow. It explains how and when to use an Option ARM to your financial advantage.

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