I have been in the mortgage industry for 20 years. (that would be 3 life times in the mortgage business!). One topic that always pops up when markets shift is “option arms”. I don’t want to go into a complete dissertation on option arms at this time, I will go into them more in depth in the future. I want to cover some basic information on them.
So, the first question is what is an option arm?
Option arms are adjustable rate loans that offer 3 to 4 different payment options each month.
Option 1: Minimum payment based on the initial start rate.
Option 2: An interest only start rate.
Option 3: Principal and interest on 30 year amortization (some are 40 year)
Option 4: Some lenders do offer a 15 year principal and interest payment.
In the last 12 months or so I have read a number of articles, that I believe were not well researched by the authors. Each article I read was in a major metropolitan newspaper. Some of the articles referred to option arms as “new fangled loans” “exotic options arms” and of course my favorite “risky interest only loans”. The latter could also be referring to interest only arms fixed for 3,5,7,or 10 years. ( I don’t find them that risky myself and I am about as conservative as you can get!)
First and foremost THESE LOANS ARE NOT NEW!!!! I don’t consider them “exotic”, derivatives on Wall Street are exotic. I also do not consider them risky, although we all have our opinion on what is risky.
Option arms were developed by the savings and loan industry to promote home ownership. Now an astute person may say “well what about the savings and loan crisis?” Why did they all go out of business? The main cause of the demise of the S&Ls were their commercial loans. The goverment allowed them to stray into commercial loans and they did a very poor job in that area. Please make a note, not all S&Ls had this problem. Some stuck with home loans only and ended up merging with other S&Ls and converting to the FDIC as banks. So………..back to the option arm genisis.
Option arms were developed to give clients the option to make different payments and at the same time protect the banks against rising rates. That way the bank was protected and the client has as well, since they could make different payments. The banks were and are not now, in the business to take property back! Taking back property is not a profit center for them, it is an expense! The loans were designed as a balance for all involved.
I personally think these are excellent loans, but THEY ARE NOT FOR EVERYONE!. We strive make sure we have the right client in the right loan. If it is an option arm, we strive to make sure it is understood correctly. There are many abuses by lenders when it comes to this loan and we strive to avoid that with clients. We use spefic spreadsheets to explain them in black and white. Many, many lenders do not even understand the loan let alone explain it correctly.
In the future, I will go into the different indices offered on these loans, what type a client are these loans good for and who they are not good for. I will also cover a bit more on the history side as well.
One last note, if you have this type of loan and you are concerned about rising rates, don’t panic. Rates will eventually cycle down as well. When we do not know, but they do. My advice is do not fall victim to lenders who call you up and tell you “you have to get out of that loan”! Lenders have a habit of telling someone in an ARM that they need a fixed rate and someone who has a fixed rate that they need an ARM. Make sure you are working with someone who has your best interest at heart and not theirs.
Until Next time,
Tim Fiero
First Capital
ABOUT THE AUTHOR Tim Fiero has been a Home Mortgage Consultant for over 20 years and is currently affiliated with HomeServices Lending.
He has earned the respect of and is referred by some of the most professional and accomplished real-estate agents in San Diego.
He loves what he does for a living, and he is really smart. You will like him. Tim can be reached at (858) 225-5541 or at tim@timfiero.com. 
on 
on 
on 
{ 1 trackback }
{ 4 comments… read them below or add one }
Great post, Tim, in terms even I can understand. From our perspective as Realtors, I think the key (as Steve has stated before) is that the clients need to understand what they are getting into. What we are unfortunately seeing is people who could only qualify for and make the payments on their home by getting an option arm and paying the minimum each month (interest only), and yet in a declining market, are getting freaked out with the acruing negative amortization (bye-bye equity). Whether or not they fully understood the implications at the time the loan was made, the people we are hearing from at least claim they didn’t. Guess who they blame? a) Their lender b) Their Realtor c) Both (a) and (b).
Tim: Sounds like you’re getting a little stressed from hearing people bitching about Option Arms. I understand and I refer you to an earlier Blog (and related comments)- “Payment Shock for Future Adjustable Mortgages”, wherein the battle was joined by Kris, Anthony and me. I understand your frustration. These loans have been around for a while. But in a previously super-low interest rate environment, together with appreciating home values there was really not much demand for them. But, after many years of significant value appreciation, at some point (starting about two years ago), there was a growing segment of people wanting to buy a home but were having trouble affording and/or qualifying for the home. Enter the old reliable Option Arm.
The fatal flaw, in my opinion, was that most buyers were betting that property values would continue to increase, even if at a slower rate. They weren’t really worried about their monthly payment (because, as you point out, it’s very flexible) or interest rate increases, as long as their property value appreciated. What they did not count on was that interest rates would increase (thus causing negative amortization – i.e., more debt tacked on to the principal balance) and at the same time their property value stays flat or, worse starts to DECREASE (Yikes!!!
). The paranoia comes in as this financially lethal combo literally eats away at the owners INPUTED equity (not equity gained through appreciation – their down payment). Worse, if you’re highly leveraged (i.e., 95%-100% financing) and need to sell (i.e., job transfer), you may be really screwed since you will probably have to put money in to get out. The icing on the cake is that most, if not all of these Option Arms come with a Prepayment Penalty that effectively prevents (or makes it REALLY painful) to refinance. I wonder, is there any way to negotiate your way out of these (short of having to sell)??
If we all heard what Tim said, then we should believe that in his professional opinion these loans are not as bad as made out to be. The fact is, even if you add to your loan balance every month, the lender is not going to call your loan due or make you start repaying on that balance until: a. your loan balance is 110% of the original balance or b. the five year period is up for recast. When Tim mentioned the fact that these loans were not new, he did not mean since 2002/2003 when the market took off. My parents had this loan 10-15 years ago.
Tim I got your back…us mortgage guys will stick together.
ha ha ha ha