Jan. 21, 2008 - Option ARMs Add to Subprime Fallout

Lenders are now starting to report a larger number of loans going into default from borrowers with high credit scores and even equity in their property.  The loans causing this new alarm are Option ARMs.  These are loans designed to give the borrower three different options with their monthly payments:

1. Borrower pays the full monthly amount due covering the interest expense with the remainder going to pay down the principal.
2. Borrower pays only the interest expense of the loan with the principal remaining unchanged.
3. Borrower pays only a portion of the interest owed with the principal increasing

After a predetermined time period these options end and a regular payment schedule is put in place. 

Option ARMs have been around for years, but just like the sub-prime lending, they have been used more prevalently for borrowers who could not qualify on any other terms.  Option ARMs are generally stated income/stated asset loans.  This means that in exchange for a slightly higher interest rate borrowers just have to tell the lender what their income & assets are and not necessarily provide proof.  The self employed or individuals with a complex financial situation are prime candidates for this type of loan.

For borrowers who were unable to qualify for a traditional mortgage, the Option ARM was given as an alternative.  The stated income could be slightly inflated in order to get the borrower into a higher priced home.  The borrower would then bank on the appreciation of their newly acquired asset and refinance before the payment schedule removed the payment options.  These borrowers are not seeing the appreciation they had hoped for and are now being forced to either sell or be foreclosed on.