Will Option ARM Loans Still Implode?

For the last year and one-half, there have been projections regarding the coming implosion of Option ARM loans. So far, it has yet to materialize on the scale that was projected. What happened to the implosion? When can it be expected? In order to answer these questions, an understanding of the mechanics of the Option ARM must first be acquired.

What is an Option ARM mortgage?

The Option ARM (sometimes marketed as “Pick-a-pay” or known as “neg-am” loans to industry insiders) was a very specialized mortgage loan program, designed originally to be used only under very specific circumstances. The primary beneficiaries of the Option ARM would be borrowers who had difficulties in documenting income as self-employed persons, or borrowers who had income streams that fluctuated monthly or with the seasons. Such borrowers would include contractors, sales persons, etc. The rationale for using such a loan was that when business was slow, the borrower could make the minimum payment, and when the borrower was busy with greater income streams, then the borrower would “catch up” on the loan by making principal reduction payments.

The Minimum Payment – This payment was based upon the Start Rate of the loan. The Start Rate was a “discounted rate” for usually one month, though it could be three months, six months or a year, depending upon the program.After the end of the one month starting interest rate, often one percent, the loan went to its Actual Rate, which will be explained shortly.

However, the borrower would still be able to make the minimum payment at the one Start Rate (often something like 1%). Since the Actual Rate of interest for second month might be something like seven percent, the loan would become a Negative Amortization (neg-am) loan, where each month that the minimum payment was made, the loan balance would actually increase.

Interest Only Payment – The Interest Only Payment would allow the borrower to only make the Interest due monthly on the loan. The loan balance would remain the same, never increasing or decreasing.

30 Year Fixed Rate Payment – This is the traditional payment on a mortgage loan, which allows for the loan to be paid off in 30 years.

15 Year Fixed Rate Payment – This is a payment amount that would allow for the loan to be paid off in 15 years.

The borrower had the option of determining which payment that he would make on the loan each month. He simply wrote out the check for whatever payment he desired, and mailed out the check.

Actual Interest Rate of the loan

The loan had a very specific methodology for determination of the Actual Interest Rate after the first month at one percent. There were two elements necessary for determination of the rate:

Index – The Index for a loan could be the LIBOR Index, COFI, CODI, COSI, or the MTA Index. The MTA, or Monthly Treasury Average, was the most popular of the Indexes used. It took the Monthly Yield on 1 Year Treasury Notes and averaged them out over a year. The Index Value to be used for each adjustment would always be the value for 45 days prior to the interest rate change date.

The Index changes monthly.

Margin – The Margin was the “markup” on the loan interest rate, which would be similar to marking up goods for purchase in a store. The Margin could be from 2.2% up to 4.5%. It was the loan officer who would determine the Margin for the loan, and not the lender.

The Margin would be added to the Index to determine the Actual Interest Rate of the loan. If the Margin was 3.7% and the Index was 2.2%, then the sum of the two would be 5.9%. However, most Option ARM Notes called for the rate to be rounded to the nearest .125%, so the effective rate for the month would be 5.875%.

Yield Spread Premium

As mentioned above, the loan officer, or broker, determined the Margin on the loan. The loan officer could provide a Margin of 2.2%, 3.00%, or whatever he wanted. One would think that the loan officer would simply give the borrower the 2.2% Margin to keep the interest rate low, but this seldom happened. That is because the higher the Margin that the broker gave a borrower, the lender would “reward” the broker with a Yield Spread Premium. On a $500,000 loan, the broker might charge a Loan Origination Fee of 1 point, or $5,000, and then receive the Yield Spread Premium of up to 4 points. For a $500,000 loan, the broker might receive a total commission of up to $25,000 per loan.

The sad fact is that most borrowers never knew this was occurring. That is because the broker seldom disclosed the Yield Spread Premium on the Good Faith Estimate. When it was revealed, and the borrower asked about this “unknown” Yield Spread Premium”, then the broker would tell the borrower, “Don’t worry about that. This is a bonus I “could” receive, once I reach a certain dollar volume with the lender, if it happens, and it seldom does. I just have to disclose the potential for it. Either way, you do not pay for it.” This was simply a lie by the broker.

Another little stunt that the broker would pull would be to charge no Loan Origination Fee and call the loan a No Point Loan. The borrower thought that the broker was being a “stand up guy”. It was never properly disclosed that the Yield Spread Premium would be paid to the broker by a higher interest rate and payment.

The end result of the broker or loan officer receiving the Yield Spread Premium would be the borrower’s payment going up considerably. On a $500,000 loan, it is common to see the payment being $500 per month or greater than what the borrower actually qualified for.

How the Option ARM really worked...

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