A Call to ARMs - Part 2

Last week we discussed the large number of 3/1, 5/1, and 7/1 ARMs that are about to adjust from the initial low rate to something in the 7% range. There is another large category of other adjustable that are already at or about to go to 7% too, and they are potentially more dangerous that the ones we discussed last week.

A large number of homes, I have heard numbers greater than 40%, that have been financed in the last few years have been with interest only or negative-amortization loans. You might ask why ARMs are so attractive given that the actual interest rates were more than tose on fixed rate loans. Normally, people would choose ARMs only when they were cheaper. The answer is that the initial attractiveness of those loans was that the initial payment was substantially lower than the traditional loan which would be amortizing over a 30 year period. Sadly, American consumers have always been suckers for a low payment rate.

To give you an idea just how attractive these are , let's look at two examples. Let's assume that our buyers need to borrow $200,000. AT 6% interest rate, the payment on a traditional fully-amortized loan would be $1,199.10. However, on an interest only loan the payment would be only $1,000, about 20% less. If they borrowers had trouble qualifying for a traditional loan, this would make it a lot easier.

Negative-amortization loans look even more attractive. Let's say the lender based the initial payment on a 1.5% start-rate. The payment on that loan is only $800, even cheaper. For some families that would make the difference between being able to buy the home or not. There is another question, however, and that is being able to afford the home.

I think that there is no question whatsoever that some of the people could have afforded the large payment but for some good reason chose to get a loan with a lower payment. Maybe they want to put their excess cash into fixing up the home or buying furniture or installing landscaping in a new home. Those people have the ability to make a larger payment when their projects are completed.

But there are others who simply cannot afford the home, but some irresponsible real estate agent and conspiratorial loan officer figured out that they could make it work, so they sold them a home. In these case, someone will have to pay the piper, and in some cases it will be sooner rather than later.

The interest only loans aren't interest only forever. At some point in time the borrower is expected to make the full payment. To reiterate our example for last week, let's say that the initial period is 5 years. At that time the borrower would be expected to make a fully-amortized payment based upon a rate of 7% over the next 25 years. That payment is $1,413.56, a whopping 41% increase over the initial payment.

With the negative-amortization ARM's it's a lot worse. After an initial period, the loan will be re-cast, at which point the borrower will need to be make a fully amortized payment. Let's use that $1,413 figure. With the real interest rates on those loans at 7% or more, that represents a 76% increase in house payment. If they borrowers couldn't afford $1,413 when they bought the home, you know that some of them can't afford it now either.

Maybe they live in an area of the country where the housing values have appreciated enough for them to sell their house and bail out without too much damage. But others will be in too deep to be able to cure the problems and they will face foreclosure.

I think that many lenders offering negative-amortization loans have not done 100% financing and many have been qualifying the borrowers on the fully-indexed rate. In their minds, the lenders are saying, "We're going to give them a break, but we're not going to lend to people who can't afford the home." But other lenders will do any loan as long as they can sell it next week to some other chump.

The concern that I have is that many, if not most borrowers who have these loans are oblivious to the train wreck that they may be headed for. They just do not look at the facts that are right in front of them. Let me give you another example. In the 1980's borrowers had a choice of three indexes to which to tie their loan's rate. Most of them, an overwhelming majority, chose the wrong one. We were in a declining rate market for 10 years and most chose the "slow-moving" index. This was the one that would assure that the lender would make the most money off of them. Today, rates are rising and again, people still have loans that will insure that they pay the most amount of money to the lenders.

Bottom line, I am not particularly optimistic that consumers are any better equipped to make sound decisions here either, especially after they probably already made one poor decision! But I keep trying to spread the word, hoping that they will start to correct their situations now, not wait until it's too late.

I hope that you'll help spread the word too by sending this to eveyone in your e-mail address book.