“… a payment option ARM allows the borrower to obtain a much lower monthly payment initially in exchange for a much higher monthly payment later. How big is that jump likely to be? Well, in one typical example that I have used involving a modest rise in interest rates of only two percent, the monthly payment can literally double overnight, at the end of the initial period.
Needless to say, that type of “payment shock” has gotten our attention. As a result, last December the bank regulatory agencies proposed guidelines to address the fundamental issues raised by nontraditional mortgages – specifically, that, over time, borrowers will experience substantial increases in required monthly payments that (1) they may not be able to afford, putting their homeownership at risk and exposing banks to substantial losses; and (2) they may not understand.” – John Dugan, April 2006
He explains why lending guidelines are needed. “If monthly payments are likely to jump because of negative amortization and/or reduced amortization periods, then lenders must take these likely increases into account in demonstrating a borrower’s capacity to meet the terms of the loan.” He expressed concern about inadequate disclosures, namely that marketing materials emphasize low intial payments and not the possibility of payments rising later.
In Dugan’s October 2005 speech, which I referred to earlier, Dugan exlains that the payment on a $360,000 option ARM (he uses the conforming loan limit) at 6% allows the borrower to make a minimum payment of $1200/month, which gradually rises to $1600/month at the end of the 5 year intro period.
At the beginning of year 6, the payment goes up 50%, from $1600 to $2500 if the interest rate is unchanged at 6%. If the interest rate has risen to 8%, the payment nearly doubles to $3,166!
So the Option ARM minimum payment doubles when the introductory period ends and interest rates have gone up 200bps. Otherwise, it only goes up 50%.
How many people can handle a 50% – 100% jump in their mortgage payment? I can say that I could *not*.
Dugan goes on to say the borrower could refinance, but what happens if interest rates have risen or the house is worth less than the new higher principal (since the mortgage increases over the 5 year period)? The borrower could be unable to refinance.
These payment shocks occur after the teaser period ends and the loan resets.
