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Loan Programs
Why an Option ARM is anything but… Well it is that time in the rate cycle again, for hordes of lenders to begin advertising an “Option ARM” at 1%-2%. The refinance boom is long since over, so it is time to try and get people to refinance needlessly anyway. I get the same mailers and e-mails all the time, so I know how tempting it looks. I think how nice it would be to actually get a 1% mortgage on my own home. Just imagine a real honest-to-goodness, principal and interest paying loan, at just 1%! But the truth is this is the biggest con job in the mortgage marketplace. The truth is you do not get 1%, except for the first month or three. The bank has absolutely no intention of letting you pay your mortgage at 1%, right from the beginning. I guess that is my biggest problem with the whole thing. The advertising is purposely deceitful and misleading. So I thought it would be worth explaining the “Real Rate” you pay on these loans. All Adjustable Rate Mortgages (ARMs) have an “Index” and “Margin” they track monthly, annually or semi-annually. This index and margin are added together at the beginning of each period. To simplify things, let’s call that your “Real Rate”. In addition, all ARMs have “Caps” or ceilings as regards to how high the interest is allowed to adjust each period, or at least over the life of the loan. Many popular ARMs also have an initial period up front, where the rate is locked-in and can’t be adjusted until that initial period has expired. Once an ARM loan starts adjusting, the bank calculates the Real Rate. This is what the bank wants, and it will never take more than rate for the next period. As long as the Real Rate does not exceed any limit set by the Caps, your mortgage rate will adjust (up or down) to the Real Rate for the next period in question. In essence there is a reasonable plan set forth, whereby both the bank and consumer can agree to share the risk of rate movements in the future. The disclosures are fairly easy to understand, and the balance of the loan is paid down over time. Many consumers have benefited from using ARMs in general. But one day many years ago, some mortgage bankers were sitting in a product development meeting somewhere in California. The question came up, “How can we create a loan whereby the consumer takes all the risk of rate fluctuations?” “What consumer would sign up for something like that? Have you been drinking your breakfast?” “No seriously. We sell it to them by leading them to believe they are getting 1% as their interest rate!” “OK, you are scaring me now. You’ve been ordering pharmaceuticals on the internet again, right?” “Hear me out. We let people make a payment that is ‘calculated’ based upon a 1% principal and interest payment. We call that payment option number #1. Then we give them a 2nd option to pay “interest-only” at the Real Rate and a 3rd option to pay (the real) principal and interest at the Real Rate. We’ll call it an ‘Option ARM’. It sounds harmless enough. Consumers will hear the 1st payment option is calculated at 1% principal and interest, and think that means they are actually paying down their loan at the 1%. It’s brilliant! We could even let that happen for the very first month, to further set the hook. When they pay at the 1% level, it won’t even cover the interest-only amount of the Real Rate (option #2). We’ll take the difference and just add it back to their principal balance. We won’t call it negative amortization any more. Instead, we’ll call it deferred interest. We can let the Real Rate adjust monthly with only a lifetime cap to limit us to 12%. So we will always get the Real Rate one way or another, and now it will start compounding on the amount we added back to their principal balance. We’ll let them run the principal balance up to 115% of the original loan amount, before we take option #1 away altogether.” “You may be on to something here. The disclosure would be mind-numbing and impossible to understand for the average guy. But we would want to have a prepayment penalty in there, because they will eventually figure out what is happening.” And that’s how the Option ARM probably came into existence. It is certainly how it “Really” works. Right now the Real Rate on all those loans is in excess of 5%. Meanwhile you could get an ARM with an initial 3 year lock on the rate for less than that, with or without the interest-only payment feature added. So any loan officer offering you this sort of thing is either a trained corporate chimpanzee, or desperate enough to have forsaken any “Real” concern for your wellbeing. Either way, you are dealing with someone who is dangerous to you financially. For expert advice on this or any other mortgage product, contact a professional. Dan Smith can be reached at 303-674-0201, or visit his website at www.coloradohomeloans.com © Copyright 2004-2007 by ColoradoHomeLoans.com |
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