Like In The Most Horrific & Scary Movie…The Audience Cries Out Watch Out!!…While The Actors Hear
One has to wonder about borrowers signing up for a new Option ARM (Adjustable Rate Mortgage) with negative amortization and low teaser rates really know what is ahead of them. The slick computer models showing ‘what if scenarios’ make the case based on given assumptions. The term negative amortization is something that will be in front of their faces real soon.
This was somewhat palatable in a rising market, but now as the market goes sideways or even down and more borrowers are finding themselves upside down while owing more than the property is worth. Much like the movies, one might take it upon himself or herself to honk at title companies, escrow officers or real estate attorneys to try and dissuade anyone from going ahead and signing a new ARM that has negative amortization. A mounted speaker on top of the car could also be employed to spout the warnings “Watch Out!”. You can be sure puzzled looks would find it’s way in the direction of the warning, wondering if this person is in their right mind. But, alas, the borrowers sign up anyway.
Fortunately, the borrowers have options. They can pay a minimum payment and let it go negative as the mortgage increases, they can pay a fully indexed interest only payment for a while with no negative amortization, a thirty year fixed payment or a fifteen year fixed payment. Each month the statement is received in the mail the borrowers have the opportunity to chose one of the options. Only the minimum payment option will give the negative amortization. For a suitable and a well financially educated based borrower this might work if there was a place for the money savings such as a business or other safe investment that is yielding a higher rate of return than the negative growth of the mortgage amount. Later on, lump sum payments can be made to offset the negative amortization from the profit gains from the investment. In that case, the money would be working harder in an alternative investment. Baring that, a borrower can be neck deep in financial trouble real quick. Qualifications for this niche product are at the fully indexed rate for debt to income qualifications. Borrowers can protect themselves, to a degree, by dealing with a lender/broker who will squeeze down the margin to a razor thin amount to keep any increases at the absolute lowest incremental amount.
As an example: Borrowers Bill and Linda have a new $300,000.00 Option ARM (Adjustable Rate Mortgage). The index for the first payment is 4.75%. The set margin as outlined in the ARM Disclosure signed and agreed at mortgage settlement is at 3.25%. Thus the fully indexed rate for the first month is the 4.75% index + the margin in 3.25% = 8.00% representing the fully indexed rate. The minimum payment option is at a rate of 1.00%. If this option is selected, the mortgage would go negative by 8.00% - 1.00% = 7.00% on an annual basis. This option would go negative by $300,000.00 x 7.00% = $21,000.00/12 = $1,750.00 negative the first month. Then the new balance is $300,000.00 + $1,750.00 = $301,750.00. This minimum 1.0% payment rate for the first month with this scenario would lead to a payment of $964.92/month with the mortgage amount going up. This is the minimum payment option. The 30-year fixed payment based on the fully indexed rate for the first month would be $2,201.29/month. The 15-year fixed payment based on the fully indexed rate for the first month would be $2,866.96/month. The interest only option for the fully indexed rate is $300,000 x 8.0% = $24,000.00/12 = $2,000/month with no amortization of the loan (no increase either). This again is the scenario with a built in 2.75% margin, which remains constant for the life of the loan. The maximum negative amortization, depending on the mortgage product can be 115% to 125% of the original balance as two of the more recognized run up limits. In this scenario it could go up to $300,000.00 x 115% = $345,000.00 or $300,000.00 x 125% = $375,000.00. Once the selected trigger limits on run up are reached, the trip wire is initiated and the loan will need to be amortized from then on at the fully indexed rate as calculated monthly. House wins. Borrower loses.
Tommy and Tammy are a “little” more astute and aggressively negotiated a margin of 2.25%. This half point difference in this scenario will be for the life of the loan. The margin is carved in stone and never changes. With the MTA index at 4.75% plus the 2.25% margin then the fully indexed rate is at 7.00% a full 1.00% below the prior example. Right from the get go the $300,000.00 x 1.00% = $3,000.00/12 = $250.00/month less than per month on the running interest meter. Again, the minimum payment at 1% the payment would be $964.92. The same as Bill and Linda’s loan scenario. However, the negative amortization would be 7.00% - 1.00% = 6.00%. The original loan amount of $300,000.00 x 6% = $18,000.00/12 = $1,500.00. The new loan balance would be $300,000.00 + $1,500.00 = $301,500.00. Because of the margin difference, Tommy and Tammy’s loan is a better deal. The 30-year fixed loan for the first month is $1,995.91/month. The 15-year fixed loan for the first month is $2,696.48/month. The interest only option at the 7.00% fully indexed rate would be $300,000.00 x 7.00% = $21,000/12 = $1,750.00/month. This loan scenario would go negative a lot slower than Tommy and Tammy’s loan.
The two loans are summarized as follows: (*negative amort.)
Loan Scenario: Margin: Current Index: Payment:Bill and Linda 3.25% 8.00%
1% Minimum Payment *$ 964.92/mo.
30-Year Fixed $2,201.29/mo.
15-Year Fixed $2,866.96/mo.
Interest Only $2,000.00/mo.
Tommy and Tammy: 2.25% 7.00%
1% Minimum Payment *$ 964.92/mo.
30-Year Fixed $1,995.91/mo.
15-Year Fixed $2,696.48/mo.
Interest Only $1,750.00/mo.
So if anyone is entertaining an Option ARM they will need to fight like a tiger to get the lowest possible margin as possible. If not deterred by all the warnings of the dangers of an Option ARM product with the audience yelling at the top of their lungs-“Watch Out”, then a borrower needs to get the lowest possible margin available on the planet. If not, bad news will follow. The next step is to lock into the most stable and reliable index possible available after exhaustive research. The broker/lender can take their fees and compensation on the front end of the mortgage origination and keep the margin as low as possible with this Option ARM product.
In conclusion, if anyone is looking at an Option ARM ‘caution’ needs to be the keyword to this consideration with eyes wide open with full due diligence. If the borrowers are going to be in the home for a few years and the property is in a slow appreciating market, later resale may be in peril if the minimum payments are made each month. If the borrower is going to be in the property for a longer term, the threat of hitting the “trip wire” for the maximum loan amount of 115% or 125% will kick in and payments will drastically go up on a forced basis. It should be noted Option ARM products contain at least a 2-year prepayment penalty. This would amount to a six-month interest on 80% of the balance. This loan of $300,000 would be with the Bill and Linda scenario: $300,000.00 x 80% = $240,000 x 8% (or at index at payoff) = $19,200.00 for the whole year or six months would be $9,600.00. The Tommy and Tammy scenario (again index at time of payoff) would be $8,400.00 if either would be paid off in the first two years.
Again borrowers ‘watch out’. If only they were listening. When things go bad with this product the credit and all that goes with it hits the fan. Foreclosures have accelerated drastically in this niche product and Congress is holding hearings. Never a good sign.
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ABOUT THE AUTHOR
Dale Rogers is a rapid rescore mortgage expert who contributes his credit repair and mortgage knowledge regularly to the Broken Credit Blog. Broken Credit Blog hosts the internet's #1 credit repair seminar. All are welcome to gain free knowledge on how to improve their credit score and obtain the lowest mortgage rates available in the market.