Orlando Mortgage Blog

This is so timely yet today, I copied it from 6/22/07:

OPTION ARM LOANS - Why I don't like them...

They go by many names. in my opinion they should be known by one: Potential TIME BOMBS! Asking some people to manage the negative amortization potential of this product is like giving a cloudy glass of water to the guy dying of thirst in the desert. He'll ask why it's cloudy later, right?

Generally known as PAYMENT OPTION ARMS. These adjustable rate mortgages (ARM) allow you the option of 4 payment methods each month. Some begin adjusting within 30 days and each thirty days thereafter. Other options can fix the payment and in some cases the rate for 3 months, 6 months, 1 year, or up to 10 years. For example purposes, I'll use a typical 5 year fixed rate option.

Basically, this mortgage has the note rate fixed (expect it to be higher than a normal 5/1 interest-only ARM) for the first five years. You may select from four payment options monthly for the first 60 payments or until a predetermined negative amortization cap is reached, usually around 115% of the initial loan amount, whichever occurs first depending on the payment method you select. Thereafter the loan enters an interest-only phase based on the current note rate until the end of the tenth year. At the end of the initial 5 years, it will adjust to a 6 month LIBOR or T-BILL index each 6 months for the life of the loan. At the end of ten years it will fully amortize (you make a full payment on the unpaid balance) for the remaining term of the initial 30 year loan. That's a mouth full, huh?

Back to the 4 monthly payment options in the first 5 years:

• You can make the minimum interest-only payment which is determined by taking the initial note rate minus 3% (which is the primary reason most borrowers are attracted to begin with). This results in negative amortization of course each month it is selected. The balance goes up in accordance to that month's interest shortfall.
• You can make an interest-only payment calculated on the actual note rate. No balance decline and no negative amortization that month.
• You can make the full interest and principal payment.
• You can pay more than the standard payment and shorten the term.

So, why do I prefer not to offer this loan to my customers? It's simple, really.

On a typical $200,000 loan you might expect an Option ARM to be priced about .50% +/- (1/2%) higher that a normal 5/1 interest-only ARM. The reason why someone might take the higher note rate ARM is because it offers a interest-only payment rate as in the first bullet point above that is 3% below the note rate each month for the first 5 years. Compared to a standard 5/1 I/O the payment difference would be a savings that month of about $500. Enough said? If they took the loan because of this lower payment option, they may continue to do so all year. That's a $6,000 shortfall or negative amortization that year. And, anything they add to their balance is now "interest bearing" too (that's how these TV ads show you the payment that's ridiculously low on that $200,000 loan amount by-the-way). Is your home appreciating by 3% or greater yearly right now? The current national annualized value has declined and year over year is down 2.7% (that's a national average $5,400 value decline on a $200,000 property). Your region or neighborhood may be more or less of course.

Real world? Sure is. I get calls from customers all the time with an Option ARM they want to get out of it. By the time they tell me their Florida home has slid a "little" in value since they bought it 2 or 3 years ago, and that their balance is now $12,000 to $18,000 higher, one of two things has become glaringly apparent. They are now going to be well over 80% financing in many cases that would require Private Mortgage Insurance (PMI) that they don't want to hear about, use a self insurance product with it's higher loan rates, or they will need to add a second mortgage to keep from having PMI. 

Many find they are up-side-down in equity and might even have to bring hundreds, if not thousands to the table (even on a true zero point quote) just to refinance it. I recently had a prospective customer that was so buried they couldn't even sell the home without bringing over $6,000 to closing. You know that made their day.

Okay, that neg-am payment looks GREAT! But, understand the potential risks. Relying on fast equity growth through appreciation to bail out of these and other quick-fix products by refinancing is at least temporarily a dream in many markets today. It could get worse if the market keeps going south.

7/2/2008 UPDATE 1 YEAR LATER! These loans have proven to be GARBAGE! Neg AM, High payments, prepayment penalties, driving people into foreclosure or terrible debt payments for years to come! I have never sold one. But I can't tell you how many people thought I was crazy for not doing them.

8/5/2008 UPATE! Why am I beating this drum again? I'm still getting flyers in the mail this week myself from companies offering this product and bragging about a great LOW Payment option with rates as low as 1%. And, I just had to turn down another one of my good previous customers for being up-side-down in equity in a big way, because someone else had since put them in one of these loans. Please read the article above before you consider this loan product!!!!!

Bill Wilbanks /  www.OrlandoMortgageMasters.com

I admit it. I've been in the mortgage industry a bunch of years (too many?). I was speaking with a long time industry friend of mine the other day about those "Good Ol' days". You know, when seasonal buyers started window shopping about February or early March each year in expectation of picking tile colors while having their new home built and finished by the start of the next school session in August or September or resale buyers that bought and closed late in the spring and through the summer for similar reasons. Or, our old friends the northern "snow birds" who flocked down the Florida vacation flyway in vast numbers during their annual migration from the sleet and snow of the northern regions to sunny Florida, home of T-shirts, shorts and flip flops as well as CHEAP winter real estate nesting grounds. 

Well...Florida hasn't been taken off the map and though we've been down thanks to an unbelievably huge wave of speculative greed for a couple years, values are once again beginning to seek rational levels, painful as the process appears to be. New buyers are slowly (I admit) starting to feed on the remains of the 2005-2006 real estate picnic and beginning the necessary purging of the over abundance of properties left on the field of play. With 24,000 plus listings on the Orlando Board's list it can't happen soon enough. But, it is starting to happen. Yes, 40% or so of sales are considered short sales, but motivated sellers can find motivated buyers at the right price and move along. Buyer affordability is at it's best level in years now too.

Lenders are starting to realize they are not landlords and are beginning to come around to the need to speed these houses off their REO (real estate owned) books. Prices are getting back to levels not seen for 5 to 6 years for careful shoppers. The main folks that are hurting are the ones that jumped in too late several years ago at the top, and generally not the folks that bought before then. Those folks are seeing a "PAPER" decline in value from the unbelievable value jumps of just a couple years ago. But, overall they should still be way ahead. First time buyers will still need a place to buy, right?

So, I'm looking for the next flock to fly in. Florida is still the Sunshine state and all those baby boomers that everyone talks about today, and will be marketing to for the next 20 to 30 years, are going to need a place to roost in the warmth of the Florida sun very soon (can you say value increases in the next 5 years?). I can't wait for my home value to turn around. In the meantime, there are deals to be had...

Bill Wilbanks / Orlando Mortgage Masters