Pay Option ARMs- the Sign of a Banking Apocalypse

My last post referenced a type of home loan called the pay option arm. It was also known as the pick a payment loan because you could pay just the interest, the interest and principal, or less than the monthly interest. The total bill you could run up by not paying the entire interest due that month was usually capped at 115% or in some cases 125% of the initial loan value. As long as the terms were understood clearly this type of loan could benefit some consumers- particularly those with irregular cash flow situations.

These loans were also often offered with extremely low initial rates such as 1.99% but with a short 1-month or 6-month period before the loan started to adjust. In addition, these loans were often approved with limited or no documentation of income and assets.

Consider this scenario, you make $45,000 a year and have approximately $2500 a month in take home pay. A $500,000 home comes up for sale near your apartment. You think wouldn’t that be amazing to live there, I’ve always loved that house. So you ask your friend who happens to be a mortgage broker what it would cost to buy that house and he comes back with- $1245 a month with no money down. And oh by the way you can borrow 103% of the loan amount so you will have a cushion in case things get a little rough. Well since you are paying $1050 a month in rent anyway and you’ve seen how much homes are appreciating in value you think, “lets go for it!”

Six months later when the 1.99% rate resets to LIBOR plus 5 or say 7.02% your minimum payment will grow 7.5% (a typical limit for the maximum payment increase at each reset) to around $1338 a month and you are paying even less of the total monthly interest! You suddenly realize you are in way over your head because at the rate you are going you will reach your 115% cap in 14 months. Oh, and home values are declining so you can’t sell your home without filing bankruptcy.

Now is it surprising that all but two of the pay option ARM lenders have failed or been bought out in the financial bloodbath? In the end the advent of the pay option ARM may have been the sign of the banking apocalypse.

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