Over the past couple of years, more and more people have been taking out “exotic loans”. Mostly, when people say, “exotic loans”, these days, they are talking about “option ARMs”.

Most commonly, option ARM loans offer borrowers four options: 1) pay an amount equal to what is due, including interest and principal; 2) pay an amount above what is due, including interest and principal; 3) pay interest only on the loan, leaving the principal balance untouched; or, 4) pay less than the minimum due.

If a borrower chooses option 4, the remainder amount due is added to the principal balance of the loan.

These loans are sometimes called “negative amortization” loans, because you end up owing more on your loan, every month you don’t pay the minimum due.

The borrower can choose any of the four options, each month.

In a perfect world, a borrower would take out this type of loan in order to give himself flexibility in payment options. For example, if someone was paid on commission, say, a real estate agent, he might take out an option ARM because he only gets paid in big chunks, every couple of months. So, in some months, he’d pay less than the minimum due (causing the loan balance to swell), but then pay off a big part of the loan’s principal balance, every couple of months, basically keeping the amount owed constant to what it would be, if he took out a regular loan.

Of course, what happened was, everyone started taking out these loans. People who had no reason to, or who wanted to make their loan payments as low as possible. Perhaps, if they wanted to flip the property, and hoped to make huge profits, in the near future.

(What is unclear to me, is whether or not a borrower qualifies for the loans based on the lower rate, or on the fully amortizing rate. If the borrower has to qualify on the lower rate, then that would explain why more and more people were taking out these loans. If the borrower still has to qualify for the regular rate, then the only people taking out these loans were regular borrowers, not those who couldn’t afford to buy, otherwise.)

Unfortunately, many of those who took out option ARMs a couple of years ago never paid more than the minimum due, so their principal balances actually increased, and now, as their loans reset at higher interest rates, they are facing higher minimum payments.

These buyers are stuck in a tough spot. They can’t afford to make their monthly loan payments (because the loans reset to higher amounts), they can’t sell their homes for what they owe (since the principal balances are now more than what they bought their homes for and since the real estate market has slowed and prices dropped), and they can’t refinance (because the cost of refinancing can be high, and/or they don’t have the money).

So, what do these buyers do?

Here are the people interviewed for a Business Week cover story, running this week:

* Gordon Burger, a 42-year-old police officer from a suburb of Sacramento, California. The payment schedule looked like what we talked about, “so I just started signing away,” says Burger. He didn’t read the fine print. “They know they’re selling crap, and they’re doing it in a way that’s very deceiving,” he says. “Unfortunately, I got sucked into it.”

* Harold, a former computer technician, who is disabled and has one source of income: the $1,600 per month he receives in Social Security disability payments. In September, 2005, Harold refinanced out of a fixed-rate mortgage and into an option ARM for his $150,000 home in Chicago.

* Billy and Carolyn Shaw are among the growing ranks of borrowers who have taken out loans they say they didn’t understand. Billy, 66, a retired mechanic, has diabetes. Carolyn, 61, has been caring for her grandchildren, 10-year-old twins, since her daughter’s death in 2000. “We didn’t totally understand what was taking place,” says Carolyn. “You have to pay attention. We didn’t, and we’re really stuck here.”

* Jennifer and Eric Hinz of Somerset, Wisconsin, are feeling the squeeze. They say they had no idea when they signed up, however, that the low payment adds $600 in deferred interest to their balance every month. Worse, they thought the 1% would last three years, but they’re already paying 7.68%. “What reasonable human being would ever knowingly give up a 5.25% fixed-rate for what we’re getting now?” says Eric, 36, who works in commercial construction. “I’m paying more, and the interest is just going up and up and up,” says Jennifer, 34, a stay-at-home mom. “I feel like we got totally screwed.”

So, what do you think? Are these people all innocent? Did they really not know what they were getting into? These are regular, hard-working people, after all. A police officer! An elderly couple! A stay-at-home mom! A disabled person!

Or, did something else happen?

More: Nightmare Mortgages – Business Week

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Updated: January 2018

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