Assume someone bought a $600,000 house with an Option ARM (also known as an “Option Adjustable Rate Mortgage”). They elect to pay the minimum payment which for our example we’ll assume is interest at 3%. Their monthly payment would be $1500. Assume at the end of five years they are subject to a recast and that they have amassed 10% negative equity and that the new rate is going to be 5%, Now they no longer have the option of paying just interest, they have to start amortizing the loan and to make matters worse, the monthly payment is going to be calculated on the remaining life of the mortgage — 25 years. Their new payment is $3,858, more than two and a half times their current payment. Oops. Negative amortization ARMs frankly never work if a housing market isn’t appreciating smartly. (Source.)
So how many of Option ARMs are out there and when do they detonate?
|From the IMF: Assessing Risks to Global Financial Stability|
This chart from Credit Suisse via the IMF shows the the reset problems with Alt-A and Option ARM loans in 2009-2011.
What is especially concerning is all these Option ARM resets in 2010 and 2011. Most of these homeowners are selecting the minimum payments (negatively amortizing) and many homeowners will be upside down when the ARM resets. Although many of the homeowners in the 2009 to 2011 reset periods will refinance (if they can), the problems in housing will linger for several years.
Clearly, the real estate market cannot bottom until we get through this.