The majority of "option" adjustable rate mortgages are due to be recast in the coming months. This means clients who appear to be in good financial shape might suddenly find themselves under water as monthly mortgage payments balloon.
The recasting of some $253.25 billion in option adjustable-rate mortgages (ARMs) has been predicted to peak between 2010 and 2012, according to SNL Financial in Charlottesville, Va. (see Figure 1).
The attractive monthly teaser rates of option ARMs helped fuel the housing boom in 2005, 2006 and 2007. These rates allowed borrowers to repay even less than interest in the first months of their mortgages.
But the chief problem with these products is the unusually large amount of "negative amortization" such repayments can trigger. In other words, the borrower's loan balance could likely exceed the amount originally borrowed. Add declining home values to the equation and you have a recipe for defaults.
"The time to start ferreting out clients with option ARM problems is now," says Chris Zehnder, a CFP and ex-mortgage banker in Saint Cloud, Fla.
Zehnder says he regularly updates his clients' net worth reports when he holds periodic meetings with them. In doing so, he has observed major shifts in clients' net worth primarily due to shifts in the value of their real estate portfolios.
When he spots a problem in the clients' portfolios, he discusses available options with them. Among the choices they have is to make loan modifications, sell the property or arrange short sales. The key, he says, is to check a client's mortgage note for the specific terms. Just because a mortgage has an adjustable rate does not mean it's an option ARM. And in the current low-interest-rate environment, automatically converting a client from an ARM to a fixed-rate mortgage could do more harm than good for certain borrowers.
An "option" or "payment option" ARM gets its name from the various payment options generally offered borrowers. Most commonly the payment options include a traditional principal and interest payment over 15, 30 or 40 years; an interest-only option; and a minimum payment option, which is generally less-than-interest-only in the first year.
The payment option selected by most borrowers during the housing boom was the deceivingly low less-than-interest-only teaser rate, which usually lasts just three months. After that, the interest rate rises to market rates, adjusting periodically. Although interest rates on this type of ARM shoot up almost immediately, most borrowers continued in the years right before the housing bust to make monthly payments based on that low teaser rate, so that additional accrued interest went toward the mortgage balance.
Meanwhile, as interest rates rose, so did the monthly payment. But option ARM terms generally limit payment increases to 7.50% annually. That means any amount over that payment cap also gets added to the loan balance.