Do home buyers with reduced-payment option adjustable rate mortgages really understand the big monthly cost increases headed their way?
Major lenders who actively pushed option ARMs during the heyday housing boom years have now scaled back, and at least one is concerned enough about the coming payment "reset" dates that it has sent letters directly to thousands of borrowers.
Option ARMs -- wildly popular in high-cost markets in California, the Southwest, and the East coast during 2003-2005 -- allow borrowers to choose to make minimum monthly payments that are insufficient to pay the full interest due or to reduce the principal. When borrowers choose that option, their deferred payments are lumped onto their principal balance -- raising the debt they owe the lender higher than their original loan amount.
The other two options available to borrowers are a fully-amortized payment -- principal plus interest -- or an interest-only payment where no principal debt is paid off. Mortgage industry research has found that roughly 75 percent of all option ARM borrowers choose the minimum payment.
Many option ARMs are scheduled to reset to higher payments this year and next -- an estimated half trillion dollars worth during 2006 alone, according to mortgage giant Freddie Mac. Federal and state financial institution regulators, along with some prominent lenders, worry that not all borrowers now making minimum payments are aware of the size of the monthly payment increases they may soon face. Worse yet, some of these loans were made to people who were on the financial bubble to begin with: their credit was stretched to make even the minimum payments necessary to afford the house they purchased.
To ward off potential reset payment shocks or misunderstandings, the largest mortgage originator in the U.S., Countrywide Home Lending, recently took the unprecedented step of proactively contacting option ARM customers who routinely have been making only the minimum payments. A copy of the prototype for all the letters was provided to Realty Times by Countrywide.
The letter says its purpose is solely to provide "an early message to alert you that, based on your current payment trends and potential future rate changes, the monthly payment that you will be required to pay in the future may increase significantly."
How big an increase might the borrower anticipate? The prototype letter, sent to a hypothetical California borrower with a $402,000 current mortgage balance, indicates that the customer's current minimum payments are running at $1,348.47. If the mortgage reset at today's applicable interest rate of 7.625 percent, the monthly payment due would jump by $1,539.13 to $2,887.60 -- more than double. If prevailing interest rates were even higher at the reset, the payment jump would be even bigger.
The Countrywide letter suggests some alternative strategies for borrowers who want to minimize the size and severity of reset payment increases. The first is to begin making full principal and interest payments every month if the household budget permits. Next would be to pay at least the interest-only amount to avoid negative amortization or build up of debt.
Finally, the letter suggests that the homeowner "explore alternative financial options" -- that is, a refinancing of the entire loan -- "that may lessen potential payment increases."
Federal and state financial regulators are expected to address the option ARM situation within the coming two months with new guidance for all types of mortgage lenders. Among the key requirements expected in the guidelines: Never extend minimum-payment plans to borrowers with sub-par credit scores, and never make loans to purchasers without thoroughly describing the mechanics of payment resets before the closing.
