ARM Payment Hikes: Another Sign of the Times

There seems to be no end to the foreclosure crisis. In fact it is likely to get worse.

Option Adjustable Rate Mortgages (ARMs) allow homeowners to choose a low minimum monthly payment typically for five years. The low monthly payments often fall short of the interest due on the loan. The difference is added to the loan balance. After five years, the loan is recast, and the monthly payments are increased to ensure full repayment of the loan by maturity. Option ARMs were originally designed for self-employed people with fluctuating incomes and gained popularity with other workers during the peak of the real estate boom in 2004, when rapidly rising home values would have otherwise kept many buyers out of the market. It peaked in the first three quarters of 2006, exceeding 15 percent of the value of all first mortgage originations, according to data from the Mortgage Bankers Association.

According to a study released by Fitch Ratings, over the next two years, $96 billion of such mortgages sold with initial flexible payment options will switch to more stringent terms. The switch will hike the homeowner’s monthly payments by about 60%. This can result in more than double the number of homeowners falling behind on their mortgage payments on such mortgages issued between 2004 and 2007. Late payments and defaults on such mortgages are already as high as 24% in some areas. The potential average payment increase on recasting loans was 63% or $1053 extra due each month. Most of these mortgages will not reach the five year period until after 2010, but many of these mortgages have a limit on negative amortization generally between 110% and 125% of the original loan amount. And when the homeowner reached this limit, the mortgage may be recast much earlier.

The combined impact of payment shock, declining home prices, and restricted availability of mortgage credit may leave many homeowners with such mortgages unwilling or unable to continue making the monthly payments.

Optional ARMs have been a boon to many homeowners who otherwise would not have been able to own homes. But now it has become a ticking time bomb waiting to explode. Lack of legislation to regulate such mortgages is one of the reasons for the present state of affairs. But the sad part is that such mortgages would not have been possible without federal laws passed in the 1980s – the Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA) and the Alternative Mortgage Transactions Parity Act of 1982 (AMTPA).

DIDMCA abolished state usury caps that had limited the interest rates banks could charge on primary mortgages – and, in the process, gave banks more incentives to make home loans to folks with less-than-perfect credit. Before AMTPA, banks were barred from making anything but the conventional fixed-rate, amortizing mortgages. AMPTA lifted those restrictions, giving birth to all the new and exotic mortgages that have so many homeowners in trouble today, including optional ARMs. There were no substitute regulations to make sure these new mortgages didn’t turn out to be exploitative.

While it’s too late for some homeowners, efforts are being made by the Congress. An October 2007 report put out by the Senate and House’s Joint Economic Committee (which is chaired by Sen. Charles Schumer of New York) recommended that underwriting standards be tightened on adjustable-rate mortgages. The report suggests that the federal government should require lenders to determine that the borrower has the ability to repay a loan at the fully-indexed rate and assume fully amortized payments.

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