Q & A with Emily Hollis

Emily Hollis
December 3, 2007 | COMMENTS

Q: We are a California credit union and have been trying to compete with an institution that is offering option ARMs. There seems to be so many different types of adjustable rate mortgages and some of the rates are very low. Can you describe the differences?

If you are located in an area that has high property values, competing with adjustable rate mortgages (ARMs) will be evident. Of the $9.2 trillion of mortgages outstanding, ARMs represent 38 percent of the outstanding principal balances. They comprise 5 percent of conforming loans and an astounding 33 percent of non-conforming loans. Forty-five percent of the non-conforming ARM loans are comprised of interest only (IO) type loans and 40 percent are comprised of option type ARMs.

The four major types of ARMs can be described as follows:

• The standard “old fashioned” ARM in which the coupon is fixed for one year and resets annually based upon an index.
• Hybrid ARMs in which the coupon is fixed for a period greater than one year, normally, three, five, seven, or 10 years and then resets annually with an index.
• IO Hybrid ARMs in which the borrower is allowed to postpone amortization of principal for a certain number of years.
• Option/Flex-Pay ARMs that offer payment options with potential for negative amortization.

Here is how an option ARM works. There is an introductory one-month period with a low teaser rate, three percent as an example. Subsequent payments are based upon a fully indexed rate. The mortgage holder has multiple options for payment based upon the following; the initial teaser rate, the fully-indexed rate, or the interest only amount calculated on the fully-indexed rate. Should options one or two be chosen, the deficit amount will be added to principal.

Every year, the mortgage payment is allowed to increase only by a predetermined amount, in most cases 7.50 percent. With a teaser rate of 3 percent, after five years negative amortization would most likely equal 10 percent of the original loan. A teaser rate of 1 percent would produce negative amortization of 20 percent in the same time period. Each individual issuer sets maximum limits on the amount of negative amortization, usually ranging from 110 percent to as high as 125 percent. Once this maximum amount is reached, the loan is recast. In other words, the borrower is forced to make payments based upon the fully-indexed rate and the higher principal balance. This could severely hurt the borrower, for payments can sometimes increase by over 100 percent.

These loans are fairly new and economists are concerned over 2003 vintage loans being recast in 2008. FICO scores have typically been above sub-prime standard, but it will be difficult for most American homeowners to see their mortgage payments increase by such potentially high amounts. If you decide to compete, make sure that your due diligence is thorough!

Emily Hollis is a CFA and president of ALM First Financial Advisors, LLC in Dallas, Texas. Contact Hollis at 800-752-4628 or ehollis@almfirst.com. Margot Strong, director of business development, may be reached at mstrong@almfirst.com.