The Hidden Perils of Option ARMs

Option AMRs, which I've blogged about before, are the latest craze, offerring consumers an option on how much to pay each month:

• A calculated "bare minimum" payment
• An interest-only payment
• A principal plus interest payment

These types of loans are commonly referred to as negative amortization loans because if the sucker borrower opts to make the "bare minimum" payments they'll actually owe more than what they owed at the start of the month. (That is, the "bare minimum" payment is less than the accrued, monthly interest.)

To attract the desperate and foolish, these loans come with a teaser rate, usually around 1%, which is good for the first year. However, option ARMs have a plethora of conspicuous 'gotchas,' as pointed out in the L.A. Times article The Hidden Perils of Option ARMs. These perils include:

• Pre-payment penalties - many loans these days carry pre-payment penalties in order to discourage consumers from refi-ing the loan early on in the loan's lifecycle. However, option ARMs commonly have a three-year pre-payment penalty not only for refis but also for paying the loan in full! That's right, if you take out an option ARM and want to sell your home two years down the road, you'll be stuck with thousands of dollars of penalty payments.
• Negative amortization - as aforementioned, when making the "bare minimum" payments consumers can quickly dig themselves into a deep hole, as they'll end up owing more at the end of the year than at the start of the year. These 'option payments' really only work for commissioned-based borrowers, or those who get a large windfall, say, every quarter or year. But for the average, salaried individual, making the bare minimum payments only spells disaster.
• The teaser rate - while that 1% teaser rate sounds nice, many folks don't realize that while the payment doesn't change for the first year the rate starts adjusting after the first month. To put this into perspective: "On a $1 million loan, a 1% option ARM with no points can add nearly $1,500 from negative amortization to the outstanding balance each month."
• Mortgage brokers are making out like bandits on option ARMs - lenders are giving brokers two to four times higher commissions on selling an option ARM over selling a more traditional loan vehicle. Clearly lenders are making out like bandits, too, on these risky loan products. Newsflash: someone is getting screwed, and if it isn't the lender and it isn't the broker, it's gotta be....... you.

The article concludes with a great quote from Mitch Ohlbaum, a West Hollywood mortgage broker: "People who know what they make each month have no business in a loan like this. They will get demolished."