Saturday, November 26, 2005

Why Option Arms Are A Bad Idea

In today's Early to Rise Newsletter (which I fully recommend EVERYBODY subscribe to), Michael Masterson wrote the following piece:

Sometimes It's Hard to Make Money Giving Good Advice
Alex, a broker and Jiu Jitsu buddy, has been telling me that he's been having a hard time selling mortgages because his customers don't want to hear his advice: that it's a bad idea for most of them to buy into the new option adjustable-rate mortgages (ARMs). (See Message #1528 .)

The Wall Street Journal reports that the big U.S. mortgage lenders are selling these "riskier" loans to protect themselves from the "possibility of a surge in defaults once the housing market simmers down." But bank regulators are worried about option ARMs. They are afraid that buyers are going to use them to get themselves into homes they can't afford.

Alex doesn't think that might be happening. He knows it. That's why he has been trying to dissuade his clients from taking such loans.

Yesterday, after training, we were talking. I asked him how things were going.

"Better now that I've given up my scruples a bit."

I asked him what he meant.

"When someone comes to me wanting to borrow more money than they should by using one of these mortgages, I tell them, 'Look, this loan is not for you. Yes, you will be fine if prices keep going up. But if they stop or even slow down, you could be cash negative.' When I say that, they look at me like I have four eyes. They say, 'Don't worry about that. The market is going to keep going up.' I used to try to persuade them to take on a more sensible loan - but then they'd leave me for someone else. Nowadays, I warn them once. Then, if they insist, I sell them what they want."

Alex told me he just sold a $640,000 mortgage to a lady who wanted to move into an $800,000 house. Her initial monthly payments are only $600. "Can you believe that!" he said, "$600 a month gets you into an $800,000 house!"

I told him I could see how tempting that must be.

"The thing is," he said, "they don't ask the right questions. They want to know how much their initial monthly payments are, and that's it. They never ask about the actual terms of the mortgage, what the real rates are, and, more importantly, what the fees and charges are."

"I guess these people have never heard of negative amortization," I said.

"Exactly," he said. "Most of them will never be able to pay off their loans."

- Michael Masterson


[Early to Rise Copyright ETR, LLC, 2004]

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I actually think Michael's friend not only was correct, but that he didn't mention that if and when the values of homes do drop and interest rates rise, there is a good chance that many borrowers will not be able to afford the increased payments on their homes. When this happens, they will be forced to sell them at a loss or lose them through foreclosure.

If you are thinking about selling your home, I believe that you should have done it this past summer, but there's still time to get it done while you can.

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