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The truth about Option-ARM’s and traditional ARM’s

What the heck is an Option-ARM and why do they get headlines?

In the Option-ARM mortgage, the borrower can decide how much she will pay each month. For example, the true Principal and Interest payment is $1,500 per month but the borrower decides to pay only $1,300 per month.

That extra $200 per month then gets added to the principal due. It adds $2,400 annually to the mortgage balance, which isn’t much when house prices are going up 10% per year.

But when the market is declining then this is a recipe for disaster. None of my clients used these mortgages and the Option-ARM product is no longer available.

OPTION-ARM’s are the single most toxic element in the existing mortgage crisis that continues to unfold across the country.

And they have tainted the reputation of traditional ARM’s… so please keep reading.

ARM is an Adjustable Rate Mortgage:

• The Interest Rate changes on a planned schedule.
• The interest rate is calculated using a specific published Index, such as U.S. Treasury or the LIBOR , that is published in The Wall Street Journal.
• On the scheduled Change Date, the Note Holder calculates a new interest rate for the mortgage by adding a specific percentage to the published Index.

The language in the Adjustable Rate Rider will read something like this:

The “Index” is the average of interbank offered rates for one-year U.S. dollar denominated deposits in the London market (“LIBOR”), as published in The Wall Street Journal. The most recent Index figure available as of the date 45 days before each Change Date is called the “Current Index”.

Before each Change Date, the Note Holder will calculate my new interest rate by adding — Two and One / Quarter – percentage points ( 2.2500%) to the Current Index. The Note Holder will then round the result of this addition to the nearest one-eighth of one percentage point (0.125%)… this rounded amount will be my new interest rate until the next Change Date.

You may not know this, but the current 1-year LIBOR rate as of 9/5/2009 is 1.27% according to The Wall Street Journal and BankRate.com.

If your 1-year, LIBOR based ARM adjusted today, using the example above, then your new mortgage rate would be 3.625%.

Here is a graph showing the history of the 1-year LIBOR Index: