Very nice post powayseller – easy to read and inviting, it makes me want to participate! Here’s my two cents on:
Option-ARMs or Neg-Ams
You’ll see Option-ARM terms described like this:
$500,000 loan, 1.5% start rate, 2.80% margin over cost of funds, 11.95% lifetime cap, 125%/10-year reset cap
The initial MINIMUM payment is based on the 1.5% start rate, and changes +/- 7.5% per year. That is a mathematical formula that has nothing to do with interest rates.
When you first hear that it’s hard to fathom how a mortgage payment can adjust with no regard to interest rates, because in every other case, it’s the interest rate that determines the payment. The minimum payment is initially based on an artificially-low interest rate, but that’s the only time it has anything to do with interest.
In this example, that MINIMUM payment is:
1st year – $1,725.60
2nd year – $1,855.02
3rd year – $1,994.15
4th year – $2,143.71
and so on.
(take the last payment X 1.075 to find new pmt.)
The FULLY-AMORTIZED payment IS figured by an interest rate, and it’s determined by adding the margin to the index. Today’s index is 4.11% + 2.80 = 6.91%.
The fully-amortized payment on the $500,000 is $3,296.35.
If you only pay the minimum payment, you ADD THE DIFFERENCE onto the loan balance. – In this case, add $1,570.75/mo.
Once you’ve added/deferred enough to reach 125% of the original loan balance, the loan resets and you then pay principal and interest monthly, amortized over the remainder of the loan.
In this example, the simple math shows that the reset kicks in around month 80, or between years six and seven. But remember that the minimum payment is going up every year, so if rates stay the same or go down, the gap is narrowed and the reset could be extended further out. In any case, the loan will reset after the tenth year – heck, you have to start paying it down sooner or later.
Obviously if rates go up, the deferred-interest gap widens, and the reset could kick in sooner.
This is your standard World Savings Neg-Am mortgage, also used by Downey Savings and Washington Mutual.
Countrywide and others tweaked the 125%/10-year reset cap to 115% or five years, and those borrowers who didn’t catch it are looking at a reset as soon as 30 months, if they aren’t careful.
The example in Business Week was a reset after 30 months, and the payment went from $1,600 to $4,000 per month. Ouch.
The mortgage industry better be working on a way to re-negotiate those terms (like raising from 115% to 125%), or they will be owning A LOT of houses in the near future. Not sure how they can re-negotiate on loans sold to MBS buyers, but somebody better do something.
If John Dugan said the payments will double when rates go from 6% to 8%, he is wrong. Payments could double (or higher) IF RESET EARLY – is the accurate fact.
Sorry for the long post, but you have the intimate details of how the Option-ARMs work.
