Dangers Inherent in Payment Option ARMs

Nearly all credit markets were brought to a standstill in the 2007 and 2008 due to poor underwriting standards and bad assumptions on future rates of home price rise. Markets and financial institutions began to re-price risks of all manners when bonds, backed by subprime mortgages, began to show default rates greater than their structures were designed to bear.

To control risk and damage to the broader economy the Federal Reserve, instituted a number of steps. A fiscal stimulus package and various programs to aid financially stressed homeowners was ratified by U.S. Federal Government.  The busting of the credit bubble was attributed to subprime mortgage problem.  However, payment option adjustable rate mortgages have the possibility for being as big of a financial disaster as subprime lending.

What are payment options ARMs?

What are payment options ARMs

Payment option ARMs (POA) are negative amortization mortgages.  Payment option ARMS (POA) were designed and marketed to borrowers with irregular income. They have low initial interest rate between 1-3.5%, fixed for up to three months. After the period designated for the initial interest rate expires, the interest rate on the mortgage is variable as per an index plus margin. Unlike other ARM products, POA borrower has the option to continue to make the initial low interest rate. This is known as the “minimum payment” option, which if the borrower opts for negative amortization is very likely to occur.

Minimum payment

When the minimum payment is less than an interest-only payment, then negative amortization occurs.

This implies that the size of the minimum payment is not large enough to cover even the monthly interest charged on the loan.

The Risk there in

The Risk there in

Borrowers opted for the POAs based on their ability to make a minimum payment. But they failed to recognize that the minimum payment would “recast” at the beginning of year six according to the terms of the mortgage. They even assumed that their home would be worth enough to refinance a different mortgage or another POA.

When a POA “recasts” the minimum payment is recalculated based on the fully indexed interest rate. This results into a substantial increase in the minimum payment

Negative amortization limit clause

All POAs have a clause called a negative amortization limit. This negative amortization limit ascertains a percentage amount of the original mortgage balance to which the current mortgage balance may increase due to negative amortization prior to an “unscheduled recast”. The limit is set at 110-125%. When an unscheduled recast is triggered, the minimum payment is reset based on the current fully indexed interest such that the new minimum payment is enough to amortize the mortgage for the remaining period.

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