“I wake up in a hotel room in Honolulu, and it’s 1941, but I mean I really wake up and it’s really 1941,” – “The Time Element” Quote from the first episode of Rod Serling’s television series, The Twilight Zone
The next category is one that many ARM loans will affect, persons with good credit, nice homes and 5/1 Interest Only ARM loans. As the reference article states (now that I have made some edits to ensure accuracy), there are various safeguards against Payment Shock in different loan terms known as Caps. Most borrowers don’t even know that there is an option to request a 2/2/5 cap structure rather than a 5/2/5 cap structure on these loans, or, when given the option balk at the higher initial interest rate for the safer adjustment cap structure. The results are predictable if you’ve made it this far . . . .
In this example, the Interest Only loan you obtained (with 5/2/5 caps, 2.25% margin and 5.01% 1 year Constant Maturity US Treasury index)for $100,000 at 4% costing $333.33 per monthly payment is now costing $722.81 to pay at 7.25% with a 25 year amortization schedule. Payment Shock factor 217% of original payment. Ouch! That smarts! Of course, during that 5 year period of initial savings, you saved a substantial amount of money to put towards this time of increased obligations, right? Not if you’re American.
Even with the 2/2/5 cap that most consumers decline to save .125% interest for 5 years ($625 payment savings over 5 years in this example), you’re still looking at a recast of $644.30 with a Payment shock of 197% which is a little closer to our tolerance levels for payment shock. At this point in the ballgame, most homeowners are refinancing when facing this type of shock. Here we go from bad to worse . . . . .
One of the prime movers on a class of loans that is and will be increasingly well known for its Payment Shock is the Option ARM, which was popularized (and at one time, even advertised and sold in retail branches) by Washington Mutual. As you might imagine, they have more experience with the loan, having beaten the fierce competition to the punch, rolling out the aggressive product at “Just The Right Time” when a consumer really could pay 1% interest on this type of loan, and amortize (pay down the balance) at that minuscule pament. Washington Mutual defines payment shock as:
A situation that occurs when an adjustable-rate mortgage (ARM) monthly mortgage payments rise very sharply at an adjustment. The borrower may not be able to afford the payments the loan will require.[Bloggers’s emphasis here]
Shame on you WAMU!
Had something like this been part of the disclosures, in simple bold letters, possibly 50% of the Option ARMs out there today would not be written.
In this, our most extreme example, but a true horror story that IS Happening to some homeowners, mostly unsuspecting ones, the 30 year Option ARM loan you obtained in December 2003 (with a 2.5% margin and 5.01% 12 month MTA average currently at 4.827%)for $100,000 at 3.75% costing $321.64 per monthly 1% minimum payment (this even paid $9.14 that month towards principal, wow!) is now a loan with a $115,000 balance costing $819.31 to repay at 7.375% over the remaining 27 year amortization schedule.
Payment Shock factor 255% of original payment.
As if to add insult to injury, the mechanics of the index dictate that you’ve still got another .25% increase coming in the next 6 months on top of that!
In the interest of avoiding Blog Shock, don’t forget that there will not be a new update until Monday morning. The next installment has to do more with the other form of payment shock, that being an overly large continuing obligation for a first time home buyer. This installment also includes some caveats about who is originating these high shock loans . . . . .