![Option ARM Reset Chart [economicpopulist.org]](http://www.getmoneyenergy.com/wp-content/uploads/2009/12/Option-ARM-Reset-Chart.jpg "Option ARM Reset Chart [economicpopulist.org]")
Option ARMs are the new subprime. Option ARMs stand for “payment-option adjustable-rate mortgages” – so-called because the rate paid on the mortgage varies with the market, but the total payment can be adjusted by the borrower according to his or her needs. How’s that for a sweet deal? It’s good right now, because interest rates in the U.S. are at practically zero.
Option ARM borrowers basically have the option to pay or practically not pay at all – by making interest-only payments or even smaller “minimum” payments. Depending on the length of the adjustment period, you might have bought a 1-year ARM, a 3-year ARM or a 5-yr ARM (in which the interest rates would reset every year, three years or five years).
Option ARMs have been called “toxic,” “the riskiest home loan product ever,” “the next shoe to drop” and classic bait and switch tricks. Typically a really low teaser-rate is offered to the buyer and after a certain amount of time it jumps back up to the conventional interest rate on mortgages. When interest rates reset, the new monthly payments borrowers will be expected to make can jump up to 5-10 times what they were used to.
Sound familiar? It should – it’s just what many credit card companies use to get you to switch your credit card balance over to their company. 0% teaser rates last for six months, but then a usually higher interest rate applies to purchases made after that period.
What’s really bad about Option ARMs is that for anyone who chooses to just pay the minimum payment, the amount of principal left to pay on the mortgage itself can actually grow. How? The principal owed grows because the minimum payment didn’t even cover the interest rate required – so the unpaid interest gets added onto the remaining balance owed and becomes part of the principal. Ouch!
Simply put, option ARMs are complicated. The average person in the U.S. taking out an option ARM is (sadly) not going to understand or take the time to learn the difference between indexes, margins, periodic-adjustment caps and lifetime interest-rate caps. It’s no wonder there’s going to be a mess ahead.
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It’s no secret that a second (or third, some would say) wave of mortgage foreclosures is due to arrive over the next two years in the U.S. – with the peak of the option ARM crisis occuring in mid-late 2011.
Subprime was bad because people who couldn’t afford homes in the first place were suckered (or made bad judgments) into homes they ended up owing more on than the mortgage became worth during the financial crisis – resulting in tens of thousands of foreclosures and abandoned homes. California was among the states the hardest hit – where companies have arisen now to take care of abandoned inground pools that became breeding grounds for rats and insects.
Option ARMs aren’t going to be any less severe. They could even be worse. This time, the mortgages will fall “underwater” because the higher interest rates will cause the principal owed to snowball – and all the while sitting in the same real estate market slump that depressed sale prices.
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Worse, option ARM owners and lenders will be between a rock and a hard place if the Fed raises rates in 2010, as many expect, in order to stem early bouts of inflation and prepare a gradual exit strategy from all the stimulus packages and quantitative easing. Andy Busch from BMO Capital Markets in Chicago even expects that we could see the Fed raise rates three times in 2010.
If interest rates start rising again, option ARM owners are going to have an even harder time because, you guessed it – the ones who couldn’t afford it in the first place are going to be the ones paying only the minimum payments – and that means they will owe more, and more, and more.
As you can see in the above chart, problems owing to option ARMs and unsecuritized ARMs aren’t expected to subside until 2013 – just about the time when the real trouble with medicare and social security payouts will be coming to a boil.
If the subprime crisis is what really kicked off the greatest recession since WW2, will the option ARM crisis kick off the “double-dip”? Some analysts don’t think so, because the bad news has been expected for some time now and “baked in” to projections and earnings estimates. Also, about 40% of option ARM owners are apparently already delinquent. Other analysts aren’t so optimistic and seem quite convinced this will be the next shoe to drop.
In addition, many distressed homeowners are expected to turn to refinancing strategies in order to keep their monthly payments small, but as we have seen, this just causes the problem to snowball. Worse, there are many mortgage refinancing scams out there.
If more defaults on mortgages occur, there will be more loan losses on the balance sheets of Bank of America, Wells Fargo, JP Morgan and other banks throughout the U.S. Sadly, a good chunk of securitized ARM mortgages is still sitting in the form of ARM bonds throughout the financial world. This is why many have called the option ARM market a “ticking time bomb.”
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{ 3 comments… read them below or add one }
Hi Clare – Not sure if you are aware, but those whose ARM’s are expiring get to refinance into similarly low rates. The 10 year yield has remained below 3.5%. The Fed Funds rate could go up a full 1-1.5%, and the 10-yr yield will still be below 4%.
It’s no big deal no matter how much the media tries to scare people to drum up business.
The problem with that line of thinking is that it doesn’t address all the problems connected to it and surrounding it. You’ve got to see these things as part of a whole ecology of global finance – not just in terms of one family’s decision-making.
Have you spoken to a mortgage broker or bank to refinance lately? Rates are so cheap.
Those who have taken ARM loans have saved a TON of unnecessary interest expense over the past 8 years, and now can refinance at the same rate. They were the financial geniuse compared to those who got a more expensive 30 yr fixed ironically.