For the past year the nation has been focused on the impact that the housing market has had on the economy. The blame has been placed primarily on sub prime or less then ideal mortgages, and rightfully so. Banks were careless in giving mortgages to essentially any one who wanted one. If you can breath, then you could get a mortgage. It didn't matter if you had bad credit, no down payment, little or no income, you could be approved. Most are optimistic that the worst is over us and that recovery will soon follow, however others will argue that option arm's will cause a new windfall refinancing mortgage troubles in the months to come.
Option ARM's are mortgages where the borrower can select one of four payment options each month when the bill comes. They can choose from a 30 year payment, a 15 year payment, an interest only payment, or a payment that is less then interest, referred to as a minimum payment. To have this flexibility in payments each month the borrower will pay a premium by way of a higher interest rate. These loans are highly profitable to lenders because of the higher rate and typically are held in house, rather then sold off in the secondary market like conventional mortgages. The option arm is a highly specialized loan that should only be sold to certain savy borrowers for a specific purpose, they are not meant for the typical borrower who is consistent in paying a mortgage for 30 years. The potential problem exists for the borrowers who elect to make the minimum payment, which is one that negatively amortizes the loan. What happens is every time the borrower elects to make this payment, they are essentially borrowing from the equity that exists in the house, causing the balance owed to increase over time.
To illustrate on a $100,000 mortgage at 5%, the interest only payment would be approximately $416/month, the minimum payment, which is determine by the loan company, could be $250. If the minimum payment is made the loan balance will increase because it is not enough to cover the interest of $416 that is accruing each mortgage refinancing The full impact of these loans have yet to realized, with unemployment at an ever increasing rate customers with these loan will resort to making the minimum payment in an effort to keep current on there monthly payments, as a result the principal balance will grow.
Combine the growing balance with plummeting property values and it exponentially puts these borrowers in a tougher position then most of your standard borrowers. The potential that these borrowers will be in over their head and owe more then the property is worth is great and will drive homeowners to just walk away completely. Anyone can see the potential problem that will exist in the months to come as these borrowers become squeezed as a result of falling home prices and massive layoffs.
Todd Savage
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