Some option ARM borrowers feel payment pinch

by Center for Personal Finance editors

NEW YORK (9/18/06)--Some cash-strapped home buyers and others who refinanced to take advantage of the benefits and flexibility of option adjustable-rate mortgages (ARMs)--with ultra-low rates and affordable payments--are beginning to experience sticker shock in a big way (Businessweek.com Sept. 11).

For some consumers, the perils of this product may outweigh the benefits. First, although an option ARM borrower can choose a low monthly payment option when money is tight, the assumption is that the property is expected to grow in value and eventually provide a decent return on the investment (Bankrate.com Sept. 2005). But unrealistic expectations of home appreciation are putting some homeowners at risk.

Second, there's the possibility that the minimum monthly payments could increase significantly from one month to the next, particularly if interest rates continue to rise.

Homeowners with shaky credit are already starting to fall behind on their mortgage payments. USA Today (Sept. 14) reports that 25% of all mortgages carry adjustable rates, and as they're reset to higher rates, more delinquencies are expected.

The situation isn't expected to improve anytime soon. Home prices are leveling off, the low minimum monthly payment of an option ARM is not fixed, and the bill is coming due. To make matters worse, some contracts contain fine print about steep penalties that now keep many borrowers from refinancing.

Option ARMs soared in popularity in recent years. In 2003, they accounted for only 0.5% of all mortgages written, but that number jumped to 12.3% through the first five months of 2006. In some parts of the country, the number is much higher--26% of mortgages in Wyoming, 40% of in Salinas, Calif., and 51% in West Virginia.

The bottom line: Know the benefits and potential risks of mortgage products before you sign on the dotted line. Read the fine print carefully, ask questions if you don't understand contract language, and talk to professionals at your credit union about different scenarios that may affect your payments--fluctuations in interest rates, home prices, and so on. Make sure you can afford the payments for the payment option you select.