"I've seen [payments] based on start rates of 0.50%," says Standard & Poor's Brian Grow, who co-authored a study suggesting negatively amortized option ARMs are prone to default.

Adds Roelof Slump, managing director of Fitch Ratings in New York: "It has been our observation that a high percentage of [option ARM] borrowers were negatively amortizing right out of the gate."

The terms of option ARMs are complex and may vary. But the payment shock typically hits when the borrower reaches one of two triggers, says the Federal Reserve. One of the triggers comes when the principal owed hits a specified threshold in the note. Generally, that's a "negative amortization" ceiling equal to 110% to 125% of the original amount borrowed. In that case, the borrower's initially flexible payment options are reduced to just one: monthly payments of both principal and interest calculated based on the remaining term.

The other trigger point usually kicks in every five years-when the loan is automatically recalculated or "recast," based on principal and interest owed over the declining remaining term. The 7.50% annual payment cap is removed for this five-year recalculation, the Federal Reserve warns.

The danger is that the option ARM's loan balances and payments will escalate amid lower home values. The payments can rise significantly if the minimum payment rate moves up to the full interest rate, if there's a requirement that principal be added to the monthly payment and if the borrower is forced to pay back an escalating loan balance triggered by negative amortization, the S&P study indicates. 

Fitch reported in 2009 that when option ARM monthly payments are recast, the payment increases average 63%. Since then, thanks to record-low interest rates, that payment shock is believed to have ebbed-at least, for now.

Standard & Poor's research indicates that once the loan balance exceeds the home's value, the borrower is more likely to default. As for all the government loan modification programs aiming to curb defaults, "the only [remedy] that will really help the option ARMs is principal forgiveness," says Nancy Reeis, co-author of the Standard & Poor's study. But analysts agree that few lenders are forgiving principal on option ARMs.

So far, according to Standard & Poor's research, the majority of option ARM loans that reached their negative amortization limits are in default. That includes 55% originated in 2005 and 70% originated in 2006, Reeis says. However, about 50% of the outstanding option ARMs originated in 2005 have yet to be fully recast to include principal and interest. About 75% and 90% of those originated in 2006 and 2007, respectively, have yet to be recast.

Financial planner Zehnder suggests that advisors look over the terms of the mortgage note in their clients' closing packages. If that's lost, "I suggest they get with the title company or attorney or the real estate agent who closed on the deal," Zehnder says.
He often puts on his banker's hat to see whether the loan payment is affordable for his client. If the monthly mortgage payment is 50% of income, you may need to talk with someone about a short sale, or try to find something more affordable, he says.

For heavily leveraged borrowers, Zehnder has had success getting mortgages refinanced through the Farmington Hills, Mich.-based Mackinac Bank. Federal programs will refinance as much as 125% of the home's value, he adds.
For a short sale, Zehnder advises talking to a real estate professional. Consider a realtor who has a "CDPE" designation issued by the Distressed Property Institute in Austin, Texas. You'll need to determine the property's market value. Area sales records may be online with the property appraiser's office. Web sites such as www.zillow.com also provide information, though online sales data may quickly prove outdated. "The lender won't even talk to you until you have an offer," Zehnder warns.