Let's say that you were one of the unfortunate ones that took out such an financial instrument back in 2006 during the frenzy of the real estate bubble. Today, you are wondering how your P&I monthly payment just went from $833 to $4,027. Wonder no more, just read on.
When an Option ARM reaches (typically) some term of years, usually five years, or principal balance (125%) it is forcibly recast to a fully amortizing loan on the original terms.
Let's say the "Option ARM" is to make a 2% interest payment on a $500,000 loan. The normal interest rate is 6% and the "full term" is 30 years. A full P&I payment is $2,953.48. But a 2% Option Arm, interest payment is $833.33; the rest is "capitalized,” or approximately $2,120/month.
When the loan hits the hard recast limit, whether on principal balance or time, you must then make a fully amortizing payment on the balance over the remaining original term.
So let's assume you have a 125% negative amortization cap. At roughly $25,000 ($2,120 x 12) in negative amortization per year, you can make minimum payments for about five years.
Now, you have 25 years to amortize $625,000 @ 6%. Your home is worth half of the original balance, or $250,000. And you have a big problem, because the fully amortizing payment on that $625,000 is $4,026.88 or 483% - nearly five times - your "option" payment!
The real problem is that many of the people who received these $500,000 loans had gross family incomes under $100,000. The fully amortizing recast payment is now nearly $50,000 annually! Now, how many of these individuals, who took out these Option Arms that I just explained and illustrated, do you believe understand the concept and the ramifications that I just went through? I know the question is rhetorical. Therefore, I will give you the answer, which is ZERO.
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