Option ARM mortgages are dangerous as rates rise

Useful and flexible option ARM can become a burden in a hurry

We have written before about the dangers of Option ARM mortgages. These loans offer a tremendous amount of flexibility, but can quickly become a burden if rates change or if you do not understand how they work. Many people who have such loans do not understand how they work, simply because they listened to a broker’s speech about how they could use an option loan to move into a house that seemed to be unaffordable. The lender said it was possible, so the buyers jumped in and took the loan without examining all of the things that can go wrong.

As interest rates continue to rise, the things that can go wrong with an option mortgage are becoming more and more obvious to the homeowners who have them. Option ARM loans are perhaps the most flexible loan type on the market today. The mortgage offers buyers as many as four different amounts that they may choose to pay each and every month:

• Minimum amount - This is an amount based on a super-low, “teaser” interest rate that may have been as low as one percent. This minimum amount is so low that it doesn’t even cover the interest that the loan has accrued during the month. After making this minimum payment, you will actually owe more than you did the month before.
• Interest only - This amount pays only the interest that has accrued on the loan during the month.
• 15 year amortization - An amount that will pay off the house in fifteen years if made every month
• 30 year amortization - An amount that will pay off the house in thirty years if made every month.

If the homeowner pays the third or fourth option, everything is fine. The second option is merely treading water; sooner or later, the homeowner has to pay some of the principal. It is the first option that has gotten many homeowners in trouble. That amount doesn’t even begin to contribute towards paying off the loan. Paying the minimum amount will actually cause the amount that you owe to increase. This is worsened by the fact that these loans have variable rates, and rates are rising. Rising rates will increase the rate at which the amount you owe goes up. Once you reach a certain threshold, the lender has the right to call you in and “recast” the loan.

What that means, in essence, is that you will be forced to refinance your loan and convert it into some type of mortgage that will require you to make payments on the loan’s principal. The amount that triggers a recast of the loan varies, but it is generally about 125% of the original loan amount. At that point, you get a new loan for far more than you originally borrowed.

And guess what? Many people who took out these loans could only afford the minimum payment in the first place. Once their loans are recast, they will find themselves with houses that they cannot afford. Worse, depending on their local market and when they bought the house, they may find themselves with houses that they both cannot afford and cannot sell. 

For some buyers, rising rates are about to cause their situation to go from bad to much, much, worse.