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Dissecting an Option ARM: why they are minefields

 
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PostPosted: Thu Feb 23, 2006 9:29 pm GMT    Post subject: Dissecting an Option ARM: why they are minefields Reply with quote

Today I spoke with a friend of mine who is looking to purchase a home. Fortunately, he is a looking in an area where prices are not as disconnected from fundamentals as Boston, but unfortunately he was planning to use an Option ARM loan to do this. I was aware that these were considered risky loans because they allow (and even encourage) negative amortization, but I didn't know enough beyond that to offer a compelling rationale for why they should be avoided if you are aware of the risks and just ignore the riskier options. Afterward, I did a little research into this to see how dangerous they really are, and it turns out that there are other problems beyond just having too many choices. My reply is below, edited for public consumption. The loan being considered was the "Power Option Loan" from World Leadership Group / Global Equity Lending.

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After researching the loan product that you mentioned today, I would recommend that you not use it. Sorry for the novel of an email that follows, I just found a lot of red flags.

I found the web page describing the Global Equity Lending "Power Option Loan" and it sounds exactly like an Option ARM. I suspect they gave it a different name because Option ARMs have been receiving a lot of negative press recently for their potential dangers, much like ValuJet changed its name to AirTran in hopes that people would stop associating them with plane accidents (whether deservedly so or not). I think this is the web page describing the loan that you mentioned:

http://www.wlgweb.com/Lending/Products/poweroption.asp

A quick search on Google for "option arms dangerous" and its variants will turn up plenty of material describing why these loans are very bad news. Some people even consider them the worst type of loan you can get (and they may be right).

However, you don't have to look any further than Global Equity Lending's own web page for the loan to see what's so bad about these things. Take a look at the payment stub in the middle of the page which gives an example of what you might pay for the first month for a $200K loan. Note the four payment options on the right. The interest only option is $1,038.50. When you pay the interest only option, your principal remains unchanged, you are not reducing debt, and you are not gaining equity - you would owe the full amount of the loan if you paid this every month and then sold the house. Now note that the option above (the "minimum amount due") is actually less. This is because you are actually increasing your debt with that option! You will lose equity and when you go to sell your home you will actually have to pay back more than what you borrowed.

You may say OK, that's fine, we'll just ignore the first two options and always pay a little more than the interest only option. That might be fine if the rest of the loan was a good deal, but it isn't - all the things that make the loan look attractive in fact only apply to the minimum payment.

Let's start with the low monthly payment. I'm relatively certain that the $420 monthly payment that you thought would accompany the loan is for the minimum payment only and assuming the lowest possible introductory rate. If you want to avoid going deeper into debt, you'll need to pay substantially more than that. Based on their example, for which you are borrowing 25% less, if we reduce the options by 25% we get a payment of $921.72 if you want to use the cheapest pre-calculated option that pays down debt. I would expect the actual number to be more than that since their example is probably skewed toward the most favorable terms that they would ever offer and the actual terms the average person would get would most likely be higher.

Next consider the "cap" on the rate increases - this is extremely critical (possibly the most important point). The cap is on how much your minimum payment increases each year, not on the interest rate that determines the total amount that you owe. See Global Equity Lending's own website to verify this:

http://www.wlgweb.com/Lending/Products/powerworks.asp

The cap of a 7.5% increase per year applies *only* to the top option in the bill that they send you and that is effectively a meaningless protection because the total that you owe is going to be growing at some unrelated rate and when you need to sell your house later the total that you owe is all that will matter. The 7.5% cap on increases to the minimum payment really only matters if you plan on paying the minimum every month, which is something that you should definitely not do. Incidentally, I know you had mentioned that there would be a cap of 0.075% and not 7.5% and I was scratching my head for awhile trying to figure out if there was a miscommunication, but I assume that would mean that if you got the introductory rate of 1%, then that would not increase by more than 0.075% per year. Obviously, that wouldn't hold with an introductory rate of 3%. Less obviously, the increase can definitely be more than 0.075% of the total in subsequent years because the cap is based on the previous year. For example, if it starts at 1% and goes to 1.075% the second year, the next year it will go to 1.155625%, which is an increase of 0.080625% for the total rate. That may seem negligible, but it will add up very quickly - by the 10th yearly increase, the increase will add 0.143793% onto the total, nearly double what you were expecting.

It isn't even a real cap, either! Look at the way they deceptively worded it: "Payment is fixed for a 1-year period and will increase annually for five years thereafter at a rate not greater or less than 7.5% of the previous year's monthly payment." That is very deceptive. They make it sound like it is a cap by saying "not greater" but then they throw in "or less than", so what they are effectively saying is that the increase will be exactly 7.5%! Why would they word things like that if not to deceive? Frankly, that seems pretty shady to me. Also note that there are no assurances about what happens after five years.

This is all tangential, though - the core point is that the introductory rate you were quoted and the cap (or "increase" to be more accurate) only apply to the minimum monthly payment. It seems like they are intentionally not doing a very good job of making it clear that is what the attractive sounding rate applies to.

So what rate applies to your total loan balance? Again, refer to their own web page for the product:

http://www.wlgweb.com/Lending/Products/powerworks.asp

The rates are set based on a lending index plus a markup, which they refer to as margin. The indexes change continuously and as a result the rate that is applied to the total of your loan may adjust every month. There also doesn't appear to be any introductory rate for this - you will be accruing debt from the start at whatever this rate is, and I assure you it will be much higher than the 1-3% rate that you were quoted. The example that they gave was for a margin of 3.25% added to the COFI index. The latest number for the COFI index that I found (at http://www.fhlbsf.com/cofi/monthly/monthly.asp ) is 3.296%. They add the two together and then round up, so your actual rate would be 7%, if I am reading everything correctly. That actually sounds higher than what a fixed rate mortgage would be right now, so even in this light the loan sounds like it's a bad deal. Furthermore, the COFI index is usually quite a bit higher than it is now, at least according to the chart at http://mortgage-x.com/general/indexes/cofi.asp , and it is on its way up, so I would expect the rate to increase much higher than that.

So in summary, I would avoid this loan because the minimum payment option is dangerous, the terms are misleading, and the less dangerous payment options don't appear to be a good deal compared with traditional loans. If you pay the introductory rate of 1-3%, it will actually increase the total amount that you owe - the true rate if you want to pay down the debt will be much higher. Let me know if I can clarify any of this.
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PostPosted: Fri Feb 24, 2006 8:16 pm GMT    Post subject: After five years Reply with quote

Ah, so here is why the Global Equity Lending website happened to not mention what happens after five years - Option ARMs generally only give you the option to pay less than the interest for the first five years. Here's an example showing how an Option ARM's payment can be a seductively low $1,035 for the first five years but then jump to $2,612 thereafter: http://www.lowelldeeds.com/blog/index.php/2006/02/14/creative-mortgages/

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