'Option' ARMs can easily confuse

By Kathy M. Kristof
Times Staff Writer

May 27, 2007

For Los Angeles newlyweds Joseph and Jamie Horton, the deal looked too good to pass up: a mortgage with an initial 1.75% interest rate and payments that wouldn't adjust for five years.

The Hortons figured that with all the money they would save on interest payments, they would be able to pay down a significant chunk of the principal on their loan. So they signed on the dotted line.

But after a month, the actual interest rate on their "option" ARM shot above 8%. They blithely made the minimum payment each month, not realizing, they say, that the low rate they had secured was so fleeting. Within months, thousands of dollars in unpaid interest was added to their loan balance. Ready to bail out, they discovered a second catch: a prepayment penalty that would cost them $18,000 if they refinanced.

"They held a carrot in front of us and told us that this was a great deal," said Joseph, 32, a vascular specialist who has since refinanced into a fixed-rate loan. "In one year, it cost us $83,000. It was just excruciating."

An option adjustable-rate mortgage is a complex type of hybrid mortgage originally designed for a narrow segment of people: sophisticated borrowers with inconsistent incomes. But because an option ARM has such a low initial payment, it became popular during the housing boom, with about $250 billion in option ARMs issued over the last three years. More recently, the loan's appeal has dimmed amid higher short-term interest rates as well as horror stories such as the Hortons'. But the mortgage is still being marketed aggressively.

If you are thinking about taking out an option ARM, here are some important tips:

Know your options

Each month an option ARM gives you a choice of four payment amounts:

• The highest amount, if paid every month, would be enough to pay your loan off in 15 years.

• The next-highest amount is calculated to pay off the loan in 30 years.

• A third option allows you to pay only the interest accruing that month — and none of the principal.

• The fourth option — the minimum payment — is the most tempting and usually the one that's advertised. It is calculated based on a "teaser" interest rate that can be as low as 1% or 2% a year. But after the first month, if you make the minimum payment, not only are you not paying down the loan, you're not even paying all the interest that's accruing. As a result, your total debt is actually increasing.

Understand the teaser

The artificially low initial interest rate on an option ARM is known as the teaser rate because it's the number that lures you into taking the loan. But although the payment may be fixed for several years, the teaser rate expires after the first month. The additional interest is added to the mortgage balance.

Jeffrey Berns, a Woodland Hills attorney representing the Hortons, says borrowers are often tricked into believing that the teaser rate will last for as long as the fixed minimum payment does.

The Hortons say it wasn't until they got their third loan statement that they realized that $2,300 in unpaid interest had been added to their mortgage balance. By then it was too late to get out of the loan.

"I may not be brilliant, but I know that 8% is higher than 6%," Joseph Horton said. "We wouldn't have turned in a 6% loan for 8% if we knew that was what we were doing."

Examine your income

Jay Brinkmann of the Mortgage Bankers Assn. says option ARMs can be good for borrowers whose take-home pay varies widely. For instance, a good candidate might be a salesperson who earns huge commissions in some months and not much in other months or a person who reliably gets a large year-end bonus. But if you have a fairly stable income, an option ARM is probably not for you.

Run your own numbers

A lender or broker may tell you that you can afford the minimum payment. But be careful. You need to assess whether you can afford the much-higher payment that would pay off the loan after the teaser rate disappears. If the answer is yes, then you probably can make the minimum payment once in a while, as long as you make catch-up payments later to bring your loan balance back to where it should be.

Don't plan to refinance

If you're thinking about getting an option ARM and refinancing if the payments get too high, don't count on it. Three things could keep you from refinancing, particularly in today's market:

• You may no longer have sufficient equity. If you borrowed $100,000 on a $120,000 property, for example, making only minimum payments could put your loan balance above the value of your home, especially if it hasn't appreciated in the meantime.

• If you struggle to make payments before trying to refinance, that could lower your credit score, making it more difficult — and costly — to refinance.

• Your option ARM will probably have a prepayment penalty, which would boost the cost of refinancing the loan.

Read the documents

The only way to really know how your mortgage works is to read the loan papers. That can mean making your way through a 2-inch stack of documents. Even then, you may run into trouble.

Jeffrey Berns, the Hortons' lawyer, is preparing a lawsuit alleging that the disclosures offered by mortgage lenders are insufficient.

"I challenge anyone to pick up a set of these loan documents and tell me what is going on," he said.

In Wisconsin, a judge cleared a similar suit for trial, saying, "An ordinary consumer reading the defendant's disclosures would be confused about the cost of the loan."

Lenders say they make every effort to ensure that borrowers understand the terms of their loans.

"We have every interest in making sure that all of our borrowers understand the product we are offering and get the loan they seek," said Tom McCormick, executive vice president and general counsel at Chevy Chase Bank in Maryland, which gave the Hortons their option ARM. "We get no benefit out of dissatisfied borrowers."

When it makes option ARM loans, Chevy Chase Bank provides a one-page disclosure form spelling out the risks of these loans in large type.

Your broker works on commission

The bigger your loan, the more your broker makes — and high fees end up fattening the broker's wallet.

Jeff Lazerson, president of a Web-based shopping service called Mortgage Grader, said high commissions for high-cost loans were one of the biggest conflicts in the real estate industry.

Consumers go to a loan broker to help them find the best deal among competing mortgage lenders, but the broker is paid by the lender based on the profitability of the loan, he said.

"The broker's incentive is not aligned to the interest of the consumer," he said. "It is truly an adversarial relationship."

The Hortons describe their mortgage experience as a year-long nightmare.

"I am embarrassed by this," said Jamie Horton, who also owns a rental home in Yorba Linda that she bought before getting married. "We are educated and successful people. I can't believe we were taken in like this."

kathy.kristof@latimes.com

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Glossary

Option ARM: An adjustable-rate mortgage designed for people with inconsistent incomes. It gives borrowers four amounts to choose from for their payment each month.

Adjustable rate: The interest rate on the loan after the first month. The rate can change every month. It has two components: the index and the margin.

Index: A widely followed gauge of market interest rates that is used to set a mortgage's adjustable rate. A common index is

LIBOR, an acronym for the London interbank offered rate.

Margin: A fixed amount that is added to the index to calculate the adjustable rate. For example, if the index is 4.36% and the margin is four percentage points, then the adjustable rate is 8.36%.

Teaser rate: The interest rate that applies during the first month of the loan's term. It is usually much lower than what the regular adjustable rate on the loan would be.

Negative amortization: An increase in the total balance owed on the loan. This occurs in any month that you make the minimum payment, because that amount is less than the interest accruing on the loan that month. The unpaid interest is added to the loan's principal.

Equity cap: The highest the mortgage principal is allowed to rise to, usually 115% to 125% of the original loan amount.

Prepayment penalty: An extra chunk of interest — in the thousands of dollars — that you must give your lender if you pay off the mortgage in the first few years (because you sold your home or refinanced). Although unusual on standard mortgages, prepayment penalties are common on option ARMs.

— Kathy M. Kristof