You may have opted for an option adjustable rate mortgage (ARM) loan a few years ago because of the advantage of no down payment, no documentation, super low interest rates, and minimum monthly payments. But current woes in the housing market may have you sweating bullets over how you're going to keep up with rising payments on your option ARM as interest rates reset and housing values fall. 

Why Choose an Option ARM?

Many homeowners were attracted in recent years to option ARMs, which have interest rates that can adjust monthly and minimum payments that adjust each year.  Part of the appeal was that borrowers could choose how much they wanted to pay each month, such as an interest-only payment, a fully-amortizing payment, an accelerated payment, or a minimum payment. This flexibility made options ARMs a great choice for people who used them wisely.

Unfortunately some people consistently chose a minimum payment option that allowed them to pay even less than the interest-only option, resulting in negative amortization, or a loan balance that increased over time. Taking on such option adjustable rate mortgage loans allowed many people to refinance their mortgage for lower payments or buy more house than they could actually afford. Adopting the minimum payment as a permanent lifestyle, combined with perhaps some economic hard knocks, and adding to that a softening housing market created a perfect storm that could sink a lot of financial ships unless action is taken soon.

Running Out of Options

Unfortunately, many of those people failed to understand the risks of using option ARMs to purchase a home.  Borrowers who took out such loans a few years ago are now facing huge jumps in their monthly mortgage payments as the loans are "recast" to become fully-amortizing. In other words, the minimum payment increases enough to pay the loan off over the remaining term at current interest rates. Homeowners have found themselves saddled with higher balances, higher rates, and shorter terms, all combining to increase payments precipitously, in some cases by thousands a month 

In late 2006, as problems heated up in the housing market, housing economist at New York's Ford Foundation George McCarthy told Business Week that the option ARM is "like the neutron bomb. It's going to kill all the people but leave the houses standing." 

LoanPerformance estimated that $581 billion in option ARM loans were written in 2005-06. Many of those homeowners are expected to default on their loans and lose their property as housing values continue to drop.   

Protect Yourself

So what should you do to protect yourself from rising payments on your option ARM? First, predict your future rate changes by running the numbers with a mortgage calculator. Second, make sure you know your loan's margin, or the amount added to the interest rate index to get your fully indexed rate. Finally, look for loans with more favorable terms. A new hybrid ARM may stop the bleeding and still give you a rate and payment you can live with. A 40 year fixed loan could stretch your balance out to create a manageable payment. A knowledgeable loan professional or financial advisor can help.

If you are in danger of being unable to refinance because your equity has eroded due to falling prices, negative amortization, or both, consider selling. Your other option may be refinancing to an FHA loan, which allows very high loan to value ratios, less stringent credit guidelines, and will even let you take cash out up to 95% if you need to. FHA loans are subject to full income documentation and loan amounts are limited depending on the county in which you live. If you think you're in deeper trouble than that, take action now.

Call a trusted loan officer, your current lender, or a HUD counselor. The sooner you get help with this the more likely you are to stay out of trouble.

Sources

Business Week

NewsMax