Rant of the Week–Marketing “Pay Option ” ARMs, the Trojan Horse loan

If anything makes me spit nails these days, it’s the way lenders are pushing “Pay Option” Arms. Back in the day, if you uttered the words “negative amortization”, people would leap up and run the other way. Everybody knew somebody with a horror story to tell. So we shelved these loans for a few years, gave them a face lift, and hauled them out to help folks buy homes they can’t afford.

My wholesalers tell me stories of new mortgage shops full of inexperienced telemarketers hyping these loans. My title company reps talk of 22 and 23 year olds bragging about the fees they’ve earned duping little old ladies. And befuddled clients file through my office each week trying to figure out this weird loan their daughter’s boyfriend put them in All too frequently, I have the unpleasant task of telling them that there’s not much they can do. You see, aside from creating artificially low payments that can jump suddenly, these loans carry stiff prepayment penalties that make them difficult to escape. And all the while, your loan balance is growing. Think of it as a Trojan horse.

But today, Wall Street is buying, so lenders are selling, hard. And what could be easier than selling a 1% rate. Even if it’s only the payment that’s fixed, a clever salesman can slip the word “fixed” into his pitch and let the borrower believe he was talking about the rate. And the reward for this institutionalised deceit? Some of the highest fees paid on any conventional loan. That combination is irresistible to the brash, greedy young salespeople who have poured into the business looking for easy money. Aside from the obvious damage done to the borrower, the indiscriminate marketing of Pay Option arms to people who should have a fixed rate will erode consumer confidence and damage our reputation.

What should you do if someone rolls this big fantasy up to your castle gates?

First, remember that if it sounds too good to be true, it is. You may be special, but not so much that you get a 1% interest rate when everyone else gets 6%. Ask about the “fully indexed rate.” That’s your real interest rate, and it’s arrived at by adding the “margin” to the “index”. It’s probably going to be somewhere in the 7% range. Keep in mind that the rate adjusts every month. Remember, only the payment is fixed.

Second, ask about the index and margin. Since the rate adjusts every month, you better make sure the index to which the loan is tied is a safe one. You want the 11th District Cost of Funds, or one of its derivatives. You do NOT want the 6 month Libor; it’s way too volatile. And if the margin is getting near 4%, your loan officer is getting rich and you’ll incur the maximum prepayment penalty of three years.

Third, ask about the prepayment penalty. You should be able to pay zero points and have only a one year prepayment penalty. I consider that a pretty reasonable trade off for eliminating any up front points. You could also pay one point and eliminate the prepayment penalty altogether. Most prepayment penalties are 6 months interest, so multiply the loan amount by the rate and divide by two to estimate the damage.

Last, ask yourself why this loan appeals to you. If it’s the only way you can afford the payment, better think twice. Despite the good things that this loan can do—and there are a couple—it isn’t a way to buy more house than you can afford, especially in this kind of market.

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