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."
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.
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
reset calculator provided
by Bankrate can be a useful tool
when evaluating what possible
payments may occur after the adjustable-rate
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.
"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.