Don't Cut Off ARMs to Spite Your Face

In all the discussion over the spreading mortgage crisis, nearly everyone focuses on how lenders made big mistakes that now threaten the health of the housing market. Yet what no one seems to remember is that the root of the problem came from the borrowers themselves.

The latest controversy comes from so-called option ARMs. These adjustable-rate mortgages come with attractive introductory rates, but more importantly, they give borrowers several choices about how much they pay each month. Instead of being locked into a particular repayment schedule, borrowers can adjust their payments to fit their circumstances. When they're flush with cash, they can make larger payments that pay down interest and principal. When times are tight, they can cut their payments to cover just the interest on their mortgage -- or in some cases, pay even less, adding the unpaid interest to their loan balance.

For borrowers who aren't careful, option ARMs can cause problems both now and later. If you make minimum payments, your total debt actually rises over time, resulting in negative equity and a potential shortfall if you have to sell. Falling home prices only exacerbate the problem. Moreover, rates on option ARMs reset after a time, which often makes payments jump dramatically. Those attributes have trapped many borrowers recently, many of whom claim that they never understood any of this could ever happen.

The wrong mindset
You don't have to look any further than the latest episode of Flip That House to understand where borrowers have gone wrong. In the minds of many, mortgage payments don't have anything to do with paying off a loan -- they're just another monthly bill that has to get paid. So if a mortgage broker gives them a choice between two mortgages, they'll take the one with the lower monthly payment -- no matter what its terms are.

Whose fault is that? Consumer activists are more than happy to blame lenders for pushing risky products on supposedly unsuspecting borrowers. Sure, plenty of players in the financial industry have made tons of money on mortgage products like option ARMs. While some banks, such as Wells Fargo (NYSE: WFC  ) and US Bancorp (NYSE: USB  ) , didn't offer them, they became a staple at Countrywide Financial (NYSE: CFC  ) and other lenders. Also, mortgage brokers often got higher commissions, as investors in mortgage-backed securities actually preferred their higher rates and (until recently) low defaults over conforming loan packages from Fannie Mae (NYSE: FNM  ) and Freddie Mac (NYSE: FRE  ) .

Yet the reality is that few of those borrowers would have been able to buy a home in the first place if products like option ARMs with negative amortized payments weren't available. Even if lenders were willing to overlook less-than-perfect credit histories, the payments on fixed loans would simply be too high. Consider this: When ARM borrowers complain that their payments are about to double, that often means their payments are rising to exactly what they would've been if they'd gotten a traditional fixed-rate loan in the first place.

What's more, you have to think that many homeowners knew exactly what they were doing. As Countrywide chair Angelo Mozilo noted in a Wall Street Journal article, many borrowers have never seen real estate values go down before. After years of seeing their neighbors and friends getting rich from the housing boom, they were willing to take whatever risks they had to in order to get in the game. Unfortunately for them, the housing market stopped churning out free money to every homeowner on the block, and they happened to be left without a chair when the music stopped.

The easy answer that will inevitably make the rounds on Capitol Hill is to get rid of these products entirely. But that won't solve the problem. Used correctly, option ARMs provide flexibility that can be extremely helpful to borrowers whose cash flow isn't steady and predictable. When lenders stretch their use to try to cover every borrower, however, they'll run into problems similar to those they're experiencing now. And unless borrowers stop thinking of mortgage debt as just another monthly bill and act responsibly, the crisis is likely to continue.

Check out these articles to learn more about:

Read/Post Comments (0) | Recommend This Article (6)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

Compare Brokers

Fool Disclosure

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 539231, ~/Articles/ArticleHandler.aspx, 10/25/2016 2:48:58 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...

Today's Market

updated 5 hours ago Sponsored by:
DOW 18,223.03 77.32 0.43%
S&P 500 2,151.33 10.17 0.47%
NASD 5,309.83 52.43 1.00%

Create My Watchlist

Go to My Watchlist

You don't seem to be following any stocks yet!

Better investing starts with a watchlist. Now you can create a personalized watchlist and get immediate access to the personalized information you need to make successful investing decisions.

Data delayed up to 5 minutes

Related Tickers

6/30/2008 4:03 PM
CFC $4.25 Down +0.00 +0.00%
FMCC $1.68 Up +0.02 +1.20%
Freddie Mac CAPS Rating: ***
FNMA $1.75 Up +0.01 +0.57%
Fannie Mae CAPS Rating: ***
USB $44.02 Up +0.17 +0.39%
US Bancorp CAPS Rating: ****
WFC $45.52 Up +0.43 +0.95%
Wells Fargo CAPS Rating: ****