Homeowners who were lured to so-called option ARMs during the big housing run-up by promises of extra-low monthly payments or 1 percent interest could soon face an ugly reality: mortgage payments that could more than double.

This surprise could kick in early next year for those who took out these loans three years ago, mortgage experts predict.

And that's not the worst of it: Borrowers who put little money down, took out option ARMs and who live in areas where housing prices have barely risen or even fallen can owe more on their house than it's worth.

Late October 2006, two U.S. Senate subcommittees were holding a joint hearing on the risks of option ARMs and other nontraditional mortgages. And federal regulators are expected soon to issue guidelines to lenders that would improve option ARM disclosures to consumers and strengthen the underwriting standards.

There is a lot of concern in the industry and among regulators that a high percentage of people taking out these mortgages will have difficulty continuing to make these payments. They will either figure out alternative ways to make payments or they will have to get rid of their homes.

Option ARMs have been around since the 1980s. Consumers advocates and mortgage experts agree that the these mortgages can be a useful tool in the right hands. But they worry that too many cash-strapped borrowers ignored their risks and used them to buy bigger houses than they could afford as home prices soared in many areas.

This adjustable rate mortgage usually allows borrowers to choose among four payment options each month. They can pay only the interest or pay principal and interest based on a 15- or 30-year term.

Or, they can make a minimum payment that doesn't cover the interest due. Unpaid interest is added to the principal, so each month the borrower ends up owing more. This is called negative amortization.

It's this payment method that worries advocates and regulators.

An option ARM can be suitable for workers whose income swings widely from season to season, These workers can make minimum payments during lean months and bigger payments when money rolls in.

But option ARMs are often touted for their low monthly payments. Among the tempting pitches on the Internet: "Lower your mortgage payment by over 50 percent." Or, "Rates as low as 1 percent on $500K."

This mortgage is the most vulnerable to misunderstanding and the most seductive.

Monthly payments are based on an artificially low interest rate of 1 percent to 3 percent. The actual rate being charged can be much higher and change monthly. Again, unpaid interest each month is tacked onto the principal, so the balance doesn't go down.

Payments are fixed for the year. They adjust annually but usually can't go up by more than 7.5 percent.

At some point, borrowers must begin repaying the principal. This usually happens at five years, but it can occur earlier if the growing balance reaches 110 percent or 115 percent of the original loan, (depends on the lender). 

Borrowers who took out an option ARM in June 2003, for example, could hit this trigger in February or March 2007 based on today's rates.

Once this happens, the mortgage will be recalculated based on the larger balance, the interest rate at the time and years left on the 30-year loan. This is how borrowers can end up with payments more than doubling.

Take the case of a borrower starting off with a $300,000 loan. The typical minimum payment would be $1,000 a month the first year.

By year four, the balance could reach the 115 percent loan limit, or $345,000. Based on interest rates now about 8 percent, the borrower's monthly payment would jump to $2,602. This can be called "Exploding ARMs".

Borrowers concerned about looming larger payments should prepare by reading their loan documents. Terms vary from lender to lender. Borrowers need to know what their mortgage payments can be under the worst-case scenario.

Then they can weigh their alternatives.

Borrowers refinancing with their same lender should ask that the penalty be waived. If that doesn't work, borrowers still might be better off paying the penalty than sticking with the option ARM.

Those only able to afford a house by making minimum payments may end up having to sell their home and buy a smaller place, That's not an easy choice to swallow.

If you need to refinance, contact me at emagen1@yahoo.com and I will be delighted to be for assistance.

October 2006