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Special section Mortgage reset

Adjustable mortgages with low introductory rates were the rage, but now the teaser rates are running out.

What is a reset?

Formula for foreclosure: resets, no equity

Loan balances rise when people make minimum payments on option ARMs, also called pick-a-payment loans. These are mortgages that allow homeowners, in some situations, to make monthly payments less than the interest charged. The unpaid interest is added to the loan balance, so the amount owed keeps rising. The technical term for this is "negative amortization." The sneaky mortgage salesman's catchphrase is "deferred interest."

Two groups most at risk
Cagan's research shows that the foreclosure wave will hit two groups of people. First are those who had relatively good credit and got mortgages with superlow introductory rates of 1 percent to 2 percent. A lot of these loans allow negative amortization, and at a certain point, their minimum monthly payments can double overnight. The other vulnerable group consists of borrowers with poor credit records who got subprime ARMs.

Subprime borrowers generally started out with rates of 6.5 percent or more. After two or three years, their rates will reset, and the monthly payments will rise. An increase of $200 per month could prove disastrous for a lot of subprime borrowers because "they are under strain already," Cagan says. Using the Mortgage reset calculator provided by Bankrate can be a useful tool when evaluating what possible payments may occur after the adjustable-rate mortgage resets.

People with low-starting-rate option ARMs tend to have fairly good credit, but the minimum monthly payments can rise too quickly for them to handle, Cagan says.

Worst in '08?
"2008 is the pinch year," Cagan says, because most subprime ARMs will hit their first adjustment that year, after being originated in 2005 or 2006. "Those two years are the peak market years -- also very generous lending years -- so you had the peak of the market, with people borrowing with nothing down or 5 percent down."

So these borrowers got loans for all or most of the home's value, and if the value falls while minimum payments rise, they're stuck. They can't refinance or sell unless they have enough cash to pay the lender the difference between what they owe and what the house is worth. They either have to keep making the payments or go through foreclosure.

The foreclosure wave won't happen all at once. It will occur over about a six-year span, Cagan estimates. "Let's say a loan resets in 2007. Maybe it resets in steps, like every six months. Maybe they can handle the next reset." Or the next. But at some point, they can't make the payments. "Then, how long does it take for a lender to take over a property? It typically takes several months, maybe a year." After that, it might take months or years for the lender to sell the property. That's why the foreclosure wave will happen in slow motion.

-- Updated: Oct. 1, 2007
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