The Exploding ARM

Why are there so many foreclosures? It isn’t because of massive unemployment or a horrible recession (although the subprime mess has caused a recession). No, the answer is simply because too many people bought more than they could afford.

Before we dive into the details of the current financial crisis, let’s look at the loan that I believe started this mess: the option Adjustable Rate Mortgage (option ARM), also known as the exploding ARM.

This loan has several options that can get a borrower in big financial trouble.

• One option provides for a very low introductory interest rate that adjusts to a higher rate after one to seven years.

• Another option allows the borrower to pay only the interest on the loan for a specified period of time and then the rate adjusts and the borrower must pay interest and start repaying the principal.

• Another option allows the borrower to pay less interest than what is due, with the balance added to the mortgage (negative amortization).

• There are many other variations to the option ARM.

Frequently option ARMs carry a pre-payment penalty. In other words, if you pay off your mortgage early or if you refinance your loan you’ll have to pay a financial penalty. Sometimes these penalties can be very, very large.

Some option ARMs carry balloon payments in which the borrower will have to pay off the loan at the end of a specified period of time. For example, the loan payments may reflect a 40-year amortization but the total amount of the loan will be due in five or seven years. For example, a $185,000 loan with a 40-year amortization schedule would mean a monthly payment of $1,083. But at the end of the 5 or 7-year period you’d have to repay the $185,000 or get a new loan. Not a bad deal if:

• Interest rates don’t go up.

• There isn’t a big pre-payment penalty.

• You can afford a traditional 30-year mortgage payment; say 6.5%, which would mean a payment of around $1,250.

• You can refinance after five or seven years. Some reasons you may not be able to refinance include:

o The bank is no longer loaning money in that particular neighborhood.

o Some of your neighbors’ homes have been foreclosed driving your property value down and now you don’t have enough equity to qualify for a loan.

o Your credit score has declined and you no longer qualify for a loan.

o You’ve lost your job or don’t have the income to qualify for a loan.