Option ARMs Misused by Borrowers and Brokers

As the mortgage meltdown attention is focused firmly on the subprime market there is a subtle, yet alarming trend emerging in special mortgages made to good credit borrowers. Option ARMs, typically made to borrowers with good credit, are estimated by Barclays Capital to reach default rates as high as 48%.

FirstFed Financial Corp, is an early example of the danger embedded in these loans. The bank posted losses near $70 million in the first quarter of 2008 after forty percent of borrowers became at least 30 days delinquent after payments surged on these adjustable rate mortgages.

Option ARMs, also referred to as Neg-Am or Negative Amortization loans, are attractive to borrowers because of their characteristically low initial payments and multiple payment options each month. However, the overwhelmingly most popular payment option--the minimum payment--is an envitable calamity for most borrowers. According to the Mortgage Banker's Association this payment preference could be as high as 90%-95%. Financial disaster looms because this minimum payment option does not even cover the interest due on the loan and continues to increase the principle balance.

The effect of routinely selecting the minimum payment option is severe payment shock when the adjustable rate period recasts, but also rapidly balloons the loan balance to as much as 110% to 125% of the value of the home. Leaving the homeowner with little options to recover, sell, or even refinance.

Early losses on these exotic loans are touching off vigorous debate in the mortgage broker community about the efficacy of Option ARMs. While some mortgage brokers, like Brian Brady from San Diego, make compelling cases for the use of Options ARMs--most are complex and unique scenarios.

Meanwhile, Todd Carpenter of Lenderama.com, may have the more accurate assessment of the Option ARM and the peril they may cause. Carpenter calls the Option ARM a "gimmick," and dangerous to all but the savviest of investors--while lenders profit heavily off the enticement of attractive, but unnecessary payment options.

Did lenders lure and mislead? It would seem certain with advertisements that routinely promising 1% interest rates and "pick-a-pay" options. Accurate, but with little hint of the complexity of the loan or the level of sophistication needed to manage this type of financing.

The debate over the legitimacy of these exotic mortgage loans will continue to rage. However, it seems certain that borrowers, even good credit ones, will continue to default at alarming rates on these loans.

Irony seems to set in when borrowers, saddled with loans sharply exceeding their home's value, are left without "options."