Interest Rate Resets On An Adjustable Rate Mortgages Are A Problem

By Author: Lawrence Roberts
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Many people took out adjustable rate mortgages during the Great Housing Bubble. After 25 years of steadily declining interest rates, people forgot about, or never knew about the risk of rising interest rates and what it would do to their housing payments. Adjustable rate mortgages are great while interest rates are declining. Their payments are lower than fixed rate mortgages, and as interest rates decline, they become an even better deal. However, when interest rates go up again, these loans will become a nightmare.

Interest rate on most adjustable-rate mortgages is lower than those for fixed-rate mortgages because the lender is not subject to interest rate risk. If interest rates rise, lenders who have issued fixed-rate mortgages have capital tied up in below-market mortgages. With adjustable rate mortgages, higher interest rates are passed on to the consumer.

The Option ARM is a hybrid adjustable rate mortgage with payment options. The interest rate being charged to the borrower is subject to periodic fluctuations with changes in market interest rates similar to other adjustable rate mortgages. The timing of ...
... adjustment and limits therein are contained in the mortgage contract.

The interest rate charged is fixed for certain periods at the end of which there is a change in the interest rate. When the interest rate changes on most adjustable rate mortgages, the payment required of the borrower changes as well. Since the charged interest rate and the payment rate are not the same for Option ARMs, the payment may not be affected and negative amortization can occur (the loan balance gets bigger.)

Since the low payment option on Negative Amortization loans is so appealing to consumers, the actual interest rate charged on Option ARMs is often higher than interest-only or fixed rate mortgages, which make these loans very attractive to investors.

Since the interest rate is higher than the payment rate, negative amortization occurs, and the loan balance grows each month as the deferred interest is added to the loan balance. This capitalized interest is recognized as income on the books of mortgage holders. Generally Accepted Accounting Principles (GAAP) allow this, but the amount of income is supposed to be reduced to reflect the likelihood of actually receiving this money. Since the loan program was new, and default rates were low due to the bubble rally, the reported income was very high making these loans even more appealing to investors.

From the investors' perspective, they were buying high-interest loans with great income potential and low default rates. From the borrowers' perspective, they were obtaining a loan at a very low interest rate, a perception rooted in a basic misunderstanding of the loan terms, and a very low payment which allowed them to finance large sums to purchase homes at inflated prices. This dissonance between the investors who purchased these loans and the borrowers who signed up for them did not become apparent until these loans began to reset to higher rates and recast to higher payments.

In short, these loans are time bombs with fuses of varying lengths set to blow up the dreams of investors and borrowers alike.

During The Great Housing Bubble these loans were widely used, and when borrowers began defaulting on these loans, a massive credit crunch ensued that sent the world economy into recession.
About Author:
Lawrence Roberts is the author of The Great Housing Bubble: Why Did House Prices Fall?
Learn more and get FREE eBooks at: http://www.thegreathousingbubble.com/
Read the author's daily dispatches at The Irvine Housing Blog: http://www.irvinehousingblog.com/ Visit Interest Rate Resets on an Adjustable Rate Mortgages Are a Problem.