Back in the halcyon days that were 2004-2006, many buyers who should have known better took out what are called “option-ARM” loans.

As you know, and as Wikipedia describes, an option-ARM is “typically a 30-year ARM that initially offers the borrower four monthly payment options: a specified minimum payment, an interest-only payment, a 15-year fully amortizing payment, and a 30-year fully amortizing payment.”

Many borrowers who took out these loans ended up paying just the minimum, which doesn’t cover the cost of the accruing interest, which is then added to the principal balance on the loan, which means your loan balance actually gets bigger, not smaller, the longer you are in your home.

At some point (115% of value, actually), the bank doesn’t let you add any more to the outstanding loan amount, and then the fun begins.

According to a recent article:

In one of the first significant studies to consider the ramifications of option ARM loans, Barclays Capital revealed that nearly 95 percent of all outstanding option ARM loans “have negatively amortized to some extent” and that the payment shock incurred when the loans reset, or recast, will be far more severe than the highly publicized subprime adjustments.

In a report titled “Option ARM-ageddon: The Real Reset Risk,” Barclays Capital researchers predicted that a majority of the existing loans would recast in 2010-11 and monthly payments would jump 60-80 percent. By comparison, most subprime resets should cause only an 8-10 percent payment shock.

The problem is easy to understand. First, many borrowers won’t be able to afford the jump in payments. Second, many borrowers won’t be able to refinance into better loans, since the values of their homes have decreased. Third, they won’t be able to sell for what they owe, not even what they owed before they started owing more.

If borrowers had paid the regular monthly payment, they would have been fine. But, there were a couple problems. First, many people who took out these loans borrowed beyond their means. So they couldn’t afford the loans from day one. And, when some borrowers financial situations changed, they were faced with the choice of making regular payments or cutting back and, of course, many cut back.

There are two parts to an “option-ARM”. The first part is the “option” of course, which is bad enough. The second part is the “ARM”. As the article mentions, rates will increase for many. But for many, rates have already increased. Many of these loans were tied to the LIBOR rate which began rising during the same time so required loan payments began to rise, right away. (For example, the LIBOR rate went from 2.17% to 4.182% in a matter of 15 months, beginning in 2005.)

Just throwing out one example, suppose you took out a $420,000 option-ARM loan back in February 2006. You had four options: pay the 15-year loan amount of $3,328, the 30-year loan amount of $2,263, the interest-only loan amount of $1,761, or the “minimum payment” amount of $1,399.

Guess which option you were likely to choose. Yes, the one where you pay the least amount, hoping that some day in the future you can “catch up”.

Bloody likely.

As you can see, these types of loans are terrible, and I would hope that someday they will be outlawed. Many major lenders have stopped offering them.

But, there are still banks who see them as viable options for some borrowers.

In theory, they are right.

In reality, it’s drinking gasoline.

( *** On a related note, when I hear people these days talking about “reverse mortgages” and how “you can’t lose”, it makes me fear that we’re in for something very similar. Reverse mortgages are a way for old people to receive some of the value for their homes while remaining in them until they die. The company buying their homes can’t kicked the people out, for any reason.

While it seems like a “win-win”, something just strikes me as risky, and I wonder if it will end up biting a lot of people in the ass, somehow.)

Source: Option ARM fallout to surpass subprime mess – By Tom Kelly, Inman News by way of Housing Intelligence