I recently heard a story of a man in San Diego who is in serious trouble with his mortgage. Even though this man makes a good living (and combined with his wife’s, are well above average), this time he really thinks he’s in trouble.
This gentleman, a 63 year-old professional, refinanced his home for $618,000 at the peak of the market with an Option ARM (Adjustable Rate Mortgage). With this Option Arm, the gentleman was able to decide which of four optional mortgage plans he would pay each month. Since refinancing, he always “chose the lowest payment” – a payment that was actually less than the accrued interest.
The gentleman and his wife had been planning on selling their home and relocating to Palm Springs after retiring at the age of 65. And even though the gentleman thought he knew what he was doing, his $2200 monthly mortgage jumped to $2700, with the dreaded fact that it could possible jump to over $4000 in the near future. And as we’ve all encountered, the sad truth is that while the mortgage on the gentleman’s home is $680,000, the net worth has dropped to approximately $400,000.
But here’s where the major problem (or opportunity) lies… Even though the housing market is moving toward recovery, there are still over a half million Option ARMS scheduled to reset within the next four years, leading to a default rate that has surpassed that of Sub Prime mortgages.
From the $750 Billion in Option ARMs made from 2004-2007, currently about one third are in default. Many of the borrowers, even the ones with a perfect payment history, are having trouble refinancing and working through this mess.
In comparison to the Sub Prime Mortgages, the borrower of an Option ARM typically had much higher credit scores, better jobs and more to lose than the masses of Sub Prime borrowers who literally walked away from their homes and neighborhoods, in droves. The Option ARMs tend to have higher balances and when they reset have been known to double the initial monthly payment.
The industry is expecting to see 600,000 or more Option ARMs reset in the next 4 years. The four payment plans that Able and other borrowers were offered included the interest only, less than the interest (where the difference would be added onto the principal – OK, when you are accumulating equity every month – but really bites in a declining market), fully amortized over both a 15 year and a 30 year fixed-rate-mortgage.
Over 75% of all borrowers never paid more than the minimal payment – less than the current interest rate plan. This plan was set to reset at either 5 years or when the new principal balance reached a pre-determined level somewhere between 110% and 125% of the original loan. Then once the ‘cap’ is reached, borrowers have to pay down a higher balance at a higher interest rate in a shorter time period.
Like so many other exotic loans, they were great products if used properly. Unfortunately industry experts expect 81% of the Option ARMs that originated in 2007 to default with many of them ending in foreclosure.
The problem is that the loans were not only offered to those for whom they were designed but to just about everyone with a decent credit score. People were not taking on these loans because they believed their income would grow over time – they were used by homeowners who believed the equity in their house would increase and that they could refinance out of the teaser rates.
The losses from Option ARMs promises to be staggering. Another industry expert is projecting at least $112 Billion will be lost by the banks as a result of Option ARMs written between 2005 and 2007.
The good news, if there is any, is that interest rates remain low – so loans are taking longer to reach their cap and will not rest at the higher interest rate until they do reach the cap.