Much has been made of the risky financing and low lending standards that have become commonplace among lending institutions over the past five years or so. As home prices escalated, the risk of interest-only, Adjustable Rate Mortgages (ARMs), and most of all the Negative Amortization "Option" ARMs, seemed academic. After all, if you get into trouble, just "pull out the equity" in your house.
I suppose I'm more conservative than most in many respects. In some ways, this may cost me. I didn't buy a house two years ago because I thought that prices had already gotten too high and I refuse to do so with any of the above mentioned mortgages. When I buy a house, it will be with a 30 year fixed, and I will put 20% down. No exception.
For what seems like the last couple of years we have heard about all of the ARM resets that were headed our way. People used these risky loans to get into houses that they couldn't actually afford. It's all part of the "monthly mentality." Who cares what the price is, just find a way to get the monthly nut into your budget, right? Wrong.
This article was written for the Wall Street Journal, and reprinted at the Post Gazette. It seems that elusive "pretty soon" when the ARMs will begin to reset, rates adjust higher, and payments spiral upward and out of control has arrived.
Some quotes from the story:
"For their new loan, Ms. Cordova-Holmes and her husband chose a so-called option adjustable-rate mortgage, which carried an introductory rate of 2.35 percent and gave her multiple payment choices each month. "I had a lot of financial obligations," says Ms. Cordova-Holmes, an accountant who lives near Detroit.
Two years later, however, the interest rate on her loan has jumped to 8.75 percent, her loan balance has climbed to $324,000 and her minimum monthly payment has risen to $2,257. She says the terms of the loan weren't clearly spelled out.
Ms. Cordova-Holmes says she would like to refinance, but can't -- in part because her loan carries a prepayment penalty that would force her to shell out thousands of dollars if she did. Instead, she's trying to sell her home"
First of all... AN ACCOUNTANT! She should be more than capable of deciphering the terms of the loan without a mortgage broker spelling it out for her. Even still, she should at least know enough to know what questions to ask.
So, given the risks, why would someone want an ARM, Interest Only or Negative Amortization Option ARM? First of all, let's discuss how these loans work.
Adjustable Rate Mortgage (ARM). These loans amortize your loan payments over a fixed period, typically 30 years. This means that at least part of your payment goes towards the principal, and your loan will be fully paid off after 30 years if you stay on track. The initial rate is lower than what you would find on a traditional 30 year fixed loan because you, not the bank, are assuming the risk that rates could rise in the future. However, as the name implies, the rate "adjusts." The most common type is the 5/1 ARM. What that means is that the rate is fixed for the first five years, and can adjust once per year after that. They often come with a rate ceiling, and a maximum adjustment amount per year. However, for many households, the maximums are well outside of their budget. This is the least risky of the risky loans. However, the benefit at this time seems limited. According to Bankrate.com, the starting rate on a 5/1 ARM is 0.29% lower than a 30 year fixed loan.
Interest Only. With an interest only loan, you do not pay anything at all towards the principal, thus they do not amortize at all. Theoretically, if your loan remained interest only forever, you would continue to owe the full loan amount as at the beginning. How this is different from renting your house from the bank, I'm not sure. The length of the interest only period varies, but typically may be 3, 5 or seven years. At the end of the interest only period, the loan become fully amortized. But your payment does not revert to the 30 year fixed rate payment because the loan is amortized for the remaining 30 years, subtracting the elapsed interest only time. So, after the 7 year interest only period, your loan would amortize over 23 years. Also, interest only loans feature ARMs (typically 3, 5 or 7 years) or a fixed rate. Of course, your payment will be less initially with an I/O ARM.
Negative Amortization "Option" ARM. This is the loan that many are referring to as a "suicide loan" or a "toxic" loan. Some experienced real estate investors may use this effectively, but I would not recommend it for anybody at any time. What happens here is that your initial payment is less than the interest due on the loan. The remaining interest amount gets added on to your loan balance. The initial payment may be as low as 1% of the loan balance. This is how our friend, Ms. Cordova-Holmes, began with a $312,000 loan and found herself owing $324,000. The rate is adjustable, and the payments will go up. Probably a lot.
Let's see some examples of how these loans work on a $400,000 loan balance. Bear in mind, I am assuming a purchase of $500,000 with 20%, or $100,000, down. Few buyers come to the table with a down like that, but let's pretend so that there is no private mortgage insurance (PMI) or piggy-back loans.
I will use the rates found on bankrate.com for the Los Angeles area.
30 year fixed: $2,416.23
30 year 5/1 ARM: $2,341.92
5/1 Interest Only ARM: $1,926.67
5/1 Neg Am Option ARM: $500.00
Do you know how a lot of mortgage brokers determine which loan is best for their client? They start at the top, and say, "can you afford that?" If the answer is no, they move down the list until the answer is yes. Even if the answer is yes at the beginning, they may follow up with, "but would this be better?"
Payment in Year 6, after the rates adjust, reset, etc. This assumes that rates adjust upwards 1.5%. It's reasonable, maybe even conservative.
Payment in Year 6
30 year fixed: $2,416.23
30 year 5/1 ARM: $2,690.17 ($348.25 more per month)
5/1 Interest Only ARM: $2,898.96 ($972.29 more per month)
5/1 Neg Am Option ARM: $3,589.35 ($3,089.35 more per month)
The 30 year 5/1 ARM may not seem like that much risk, but how would an additional $348 per month fit into your budget. You could probably handle it, but you wouldn't want to. And that assumes rates go up 1.5%. It could get much worse. Besides, you most people that get the ARM do so for the lower initial payment. The other two are just insane.
Here's my spreadsheet with the full numbers.