So we left John and Mary with the imploding, soon to be exploding, mortgage. Things to remember about the Option ARM loan:
1. There is a minimum payment (which in this case would be based on a 2% amortized payment schedule - usually this loan has a 1% start rate, but because of the loan amount the bank required 2%)
2. The payment is based on LIBOR plus a margin (hypothetically 3% - since that is what my buddy who is a mortgage officer said they charged on ALL Option ARM loans)
3. The payment goes up 7.5% each year
4. The difference between the minimum payment and the interest only payment is added to the balance of the mortgage
Now these are very rough numbers, but here is their mortgage situation.
1st - $625,000 (5.8%)
2nd - $60,000 (8.25%)
Payment
1st - $3,020.83 (I/O)
2nd - $450.76
Taxes - $572.92 (1.1%)
Insurance - $97.51
DTI: 49.7%
John and Mary would not qualify for this home if it were not for the Option ARM loan. Because of the 2% start rate...they get a qualifying payment of $3,431.31 (PITI) which leaves them with a much more manageable DTI of 41.1%.
Here is a breakdown of the yearly payments:
Year - Payment (deferred interest) - DTI
2006 - $3,431.31 (8,528.56) - 41.1%
2007 - $3,604.57 (6,449.44) - 43.3%
2008 - $3,790.82 (4,218.04) - 45.5%
2009 - $3,991.04 (1,811.68) - 47.9%
2010 - $4,206.28 (-771.08) - 50.5%
After deferring the interest, John and Mary are looking at a mortgage amount of $645.236.64 on the 1st. Don't forget that the mortgage is amortized over 25 years...because the first 5 years are gone. So, here is the payment that is sitting out in front of them.
2011 - $5,199.93 - 62.4%
The second is slightly better because they have been paying this loan down. The balance is $56,451.09. The total owed on the house is $701,687.74.
The payment is already pushing what they can afford. They no longer eat out, go on vacation, etc... If they called their mortgage company they would know that the payment in 18 months is going to be way over what they can afford.
Options
They have 4 options sitting in front of them. The first is pretty simple. They can re-fi their home and hope to take advantage of the unbelievable interest rates. A commercial on the radio is boasting of incredible rates...4.5% to be exact. John and Mary have been faithful to make all of their payments on time...their credit rating is over 750...they are great candidates.
However, re-financing the 1st mortgage is going to give them a payment of $4,363.99 (DTI of 52.4%). The result is that their payment actually goes up $157.71 per month. They will get relief of $835.94 per month over the 2011 fully amortized payment. John and Mary can probably suck it up and cover the additional payment. Except, the home is worth $375,000.
The second option is they can try to modify their loan. They can take part in President Obama's plan to help homeowners and re-structure their debt.
The third option is they can sell their home. Unfortunately, the issue of the homes worth crops up and this appears to be a dead-end for John and Mary.
The last option is to "walk away". They can stop making payments all together. They can save their money and start their life over.
Options 2, 3, and 4 need further unpacking...check back for the next post!
Showing posts with label option ARM. Show all posts
Showing posts with label option ARM. Show all posts
Thursday, May 21, 2009
Thursday, November 27, 2008
Optimists, look away now....
...is the subtle beginning to a small 4 paragraph article that appears in The Economists. I had an open mic last week and I ranted and raved about the "option ARM", "pick-a-pay", or "negative amortization loan". And this week I come across a disturbing - albeit old article (8.14.08) - from The Economist.
Here are the high(low)lights of the article:
1. 1.4 million households have the "option ARM"
2. Most of them are in California
3. Delinquencies have risen from .49% in Q4 2007 to 3.91% in Q2 of 2008
4. Most payments will surge between 60-80% when the loan recasts
5. These loans account for 45% of Wachovia's portfolio (remember I said watch Wachovia)
6. These loans account for $500 billion dollars in loans
7. The majority of these loans will begin to recast in 2010 to 2011
Commentary - 2007 and 2008 were just the beginning of what is to come. I don't know if the bailout can stem the tide that is coming, but the worst is on it's way. The horizon has more foreclosures and more bank failings.
If you want - you can read the article for yourself - option ARM!
Here are the high(low)lights of the article:
1. 1.4 million households have the "option ARM"
2. Most of them are in California
3. Delinquencies have risen from .49% in Q4 2007 to 3.91% in Q2 of 2008
4. Most payments will surge between 60-80% when the loan recasts
5. These loans account for 45% of Wachovia's portfolio (remember I said watch Wachovia)
6. These loans account for $500 billion dollars in loans
7. The majority of these loans will begin to recast in 2010 to 2011
Commentary - 2007 and 2008 were just the beginning of what is to come. I don't know if the bailout can stem the tide that is coming, but the worst is on it's way. The horizon has more foreclosures and more bank failings.
If you want - you can read the article for yourself - option ARM!
Sunday, November 23, 2008
More Banks on the Brink...
Pomona First Federal and Downey Savings are the newest members of the bank meltdown of '08. Here are some facts:
1. 22 banks have failed in 2008
2. 2 huge banks (including the biggest ever - WaMu) have collapsed
3. The biggest may still be yet to come - Citi
I completely understand why WaMu and Downey failed. Both of these institutions promoted and wildly sold the 'option ARM' home loan. This loan literally turned your house into a credit card. The borrower was basically allowed to make a chose as to which payment the wanted to make.
- minimum amount due
- interest only
- 30 year amortized
- 15 year amortized
Let me illustrate a little further. You went to buy a house for $300,000. The prevailing interest rates are (hypothetically) 6%. The 30 year fixed rate payment would be $1,798.65 principle and interest. The 5 year interest only payment would be $1,500.00. However, the 'option ARM' payment coupon would look like this:
$964.86 - minimum (based on 1% amortized 'start rate')
$1,325.00 - interest only
$1,665.91 - 30 year amortized
$2,419.51 - 15 year amortized
The last 3 were based on the 'current interest rates' for the option ARM. The rates for the option ARM were calculated by adding a margin (bank profit) to an index (MTA, COFI, COSI, CODI, LIBOR). All of these indices were operating at unbelievably low rates during '03, '04, '05 and parts of '06. However, the dirty little secret of the option ARM was that the interest rate was adjusting EVERY month. It was only moving inches at a time, but over 2 or 3 years inches become a mile.
Ok, we haven't gotten all of the nuances of this loan out yet. Probably the most dangerous part of the option ARM was the promise that the loan payment would NEVER increase by more than 7.5% per year. How does that work? Well, it simply means that the minimum payment on our above hypothetical will look like this...
$964.86 - year 1
$1,037.22 - year 2
$1,115.01 - year 3
$1,198.64 - year 4
$1,288.54 - year 5
Also, the difference from the minimum due and the interest only option was added to the back of this loan. Meaning any money you did not pay each month was added to your principle balance.
Lastly, after 5 years this loan recast itself. Meaning that it became a 'regular' loan from that point on. By regular I mean, you had to start paying it back! So, how does this effect our example above?
First, let's assume that interest rates stayed flat for 5 years. Second, we are going to assume that the buyer makes the minimum payment option (c'mon this is America). So, we are going to come up with the 'best case scenario' for this buyer.
$4,321.68 - deferred year 1
$3,453.36 - deferred year 2
$2,519.88 - deferred year 3
$1,516.32 - deferred year 4
$437.52 - deferred year 5
$12,248.76 total deferred
So, now our buyer is getting their loan recast. But, instead of it being $300,000 - it is $312,248.76. And, instead of it being 30 years, it is 25 years. So the new monthly payment is - $2,011.83. Meaning that their payment is approximately $750.00 per month more in month 61 than it was in month 60. To compound matters the real estate market is tanking (the house they owe $312,248 for is worth $200,000) and interest rates are up (LIBOR was 1.339 in January of 2003, it was 3.9091 in January 2008).
The last bit of bad news about this is that most Americans did not buy the $300,000 house. They bought the $600,000 house because they could afford the minimum payment and could for the next 5 years - because their loan officer could show them the 'fixed' minimum payment for 5 years.
This is just one of the "toxic debt" instruments that is weighing down the financial institutions in America (and the world). Alan Greenspan actually supported this loan during his tenure as the head of the FED but it may turn out being the loan that brings this country to our knees. Wachovia may be the next big bank to fall because they actually started this loan when they were World Savings.
1. 22 banks have failed in 2008
2. 2 huge banks (including the biggest ever - WaMu) have collapsed
3. The biggest may still be yet to come - Citi
I completely understand why WaMu and Downey failed. Both of these institutions promoted and wildly sold the 'option ARM' home loan. This loan literally turned your house into a credit card. The borrower was basically allowed to make a chose as to which payment the wanted to make.
- minimum amount due
- interest only
- 30 year amortized
- 15 year amortized
Let me illustrate a little further. You went to buy a house for $300,000. The prevailing interest rates are (hypothetically) 6%. The 30 year fixed rate payment would be $1,798.65 principle and interest. The 5 year interest only payment would be $1,500.00. However, the 'option ARM' payment coupon would look like this:
$964.86 - minimum (based on 1% amortized 'start rate')
$1,325.00 - interest only
$1,665.91 - 30 year amortized
$2,419.51 - 15 year amortized
The last 3 were based on the 'current interest rates' for the option ARM. The rates for the option ARM were calculated by adding a margin (bank profit) to an index (MTA, COFI, COSI, CODI, LIBOR). All of these indices were operating at unbelievably low rates during '03, '04, '05 and parts of '06. However, the dirty little secret of the option ARM was that the interest rate was adjusting EVERY month. It was only moving inches at a time, but over 2 or 3 years inches become a mile.
Ok, we haven't gotten all of the nuances of this loan out yet. Probably the most dangerous part of the option ARM was the promise that the loan payment would NEVER increase by more than 7.5% per year. How does that work? Well, it simply means that the minimum payment on our above hypothetical will look like this...
$964.86 - year 1
$1,037.22 - year 2
$1,115.01 - year 3
$1,198.64 - year 4
$1,288.54 - year 5
Also, the difference from the minimum due and the interest only option was added to the back of this loan. Meaning any money you did not pay each month was added to your principle balance.
Lastly, after 5 years this loan recast itself. Meaning that it became a 'regular' loan from that point on. By regular I mean, you had to start paying it back! So, how does this effect our example above?
First, let's assume that interest rates stayed flat for 5 years. Second, we are going to assume that the buyer makes the minimum payment option (c'mon this is America). So, we are going to come up with the 'best case scenario' for this buyer.
$4,321.68 - deferred year 1
$3,453.36 - deferred year 2
$2,519.88 - deferred year 3
$1,516.32 - deferred year 4
$437.52 - deferred year 5
$12,248.76 total deferred
So, now our buyer is getting their loan recast. But, instead of it being $300,000 - it is $312,248.76. And, instead of it being 30 years, it is 25 years. So the new monthly payment is - $2,011.83. Meaning that their payment is approximately $750.00 per month more in month 61 than it was in month 60. To compound matters the real estate market is tanking (the house they owe $312,248 for is worth $200,000) and interest rates are up (LIBOR was 1.339 in January of 2003, it was 3.9091 in January 2008).
The last bit of bad news about this is that most Americans did not buy the $300,000 house. They bought the $600,000 house because they could afford the minimum payment and could for the next 5 years - because their loan officer could show them the 'fixed' minimum payment for 5 years.
This is just one of the "toxic debt" instruments that is weighing down the financial institutions in America (and the world). Alan Greenspan actually supported this loan during his tenure as the head of the FED but it may turn out being the loan that brings this country to our knees. Wachovia may be the next big bank to fall because they actually started this loan when they were World Savings.
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