Option ARM blues

5 min read


Phil and Stacey Fleming of California are in a situation that many can identify with – raising a family in one of the most expensive housing markets in the country. Phil, 42, works in administration for a school district. Stacey, 35, works with special education students in a middle school. They have three children – two sons, ages 14 and 11, and a daughter age 8.

The Flemings purchased their home two years ago after relocating from Florida, and they intend to remain in the home for at least another 10 years. In addition to pursuing graduate studies at the University of Southern California, Phil has been spending his weekends renovating the home for the past two years.

The Flemings

The challenge: Used an option ARM to buy their home; mortgage now larger than when they bought house.
The plan: Get finances in shape to make refinancing to a fixed rate possible.
Follow-up: Able to increase savings while refinancing to a low-interest, fixed-rate mortgage.

The problem

The Flemings face a situation thousands of recent home buyers can relate to. Their option ARM started off great but is now zapping their bottom line.

Phil and Stacey bought their home with an option ARM and are finding it increasingly difficult each month to make a payment large enough to actually reduce their mortgage. The balance on the loan has increased by $30,000 since the loan originated two years ago. Further, they say they cannot make the higher interest-only payment, much less a payment that is going to chip away at the loan balance.

An option ARM permits borrowers to choose how they wish to make their payments each month: a traditional, fully amortizing payment; an interest-only payment; or a minimum monthly payment that is often not enough to cover the interest due. While Phil acknowledges the loan “was originally attractive for its low monthly payment,” they’ve also learned over the last two years that rising interest rates mean higher monthly payments. They resort to the minimum payment each month, and watch as the interest-only payment continues to ratchet higher.

This may seem like a cut-and-dry issue, but for a more complete perspective, we reviewed Phil and Stacey’s overall financial picture.

Over the past two years, Phil has spent weekends fixing up the home, doing the labor himself and sometimes with the help of their 14-year-old son. The costs for materials have been absorbed by a home equity line of credit. As the outstanding balance on that line of credit has grown, rising interest rates have helped push the interest-only payment steadily higher. The couple makes just the interest-only payment each month. Phil expects to incur another $8,000 to $10,000 in home improvement expenses over the next year to complete the job.

Between rising interest rates, the increasing home debt and a schedule that constantly has them on the go, Phil and Stacey are starting to feel the strain.

Flemings’ financial picture

They have two car loans, $5,600 in credit card debt, student loan debt from Phil’s undergraduate days, and expect another $1,500 in costs for the graduate program in which Phil is currently enrolled.

While Phil works year-round, Stacey is off during the summer. With Stacey home during the summer, and the close proximity of their home to the school where she works, they are able to avoid burdensome child care expenses.

While they don’t adhere to a budget, Stacey keeps detailed records and uses Quicken to help manage their finances. By “paying things as they come in,” Phil and Stacey have good credit that has afforded them attractive interest rates on all of their borrowings.

Their property taxes are not escrowed, but they are disciplined about setting money aside into a dedicated account monthly and pay in two installments each year. This system has worked well, although they admit that they must occasionally tap that account when income is lean, particularly in the summer months when Stacey is home.

Phil and Stacey try to minimize expenses by shopping around, hunting for bargains and seizing opportunities to cut costs. They consolidated Phil’s undergraduate student loans at a very attractive interest rate using a program that calls for gradual payment increases over time. One credit card balance has a zero-percent promotional offer scheduled to end in March.

Although Phil has seen a significant increase in income in the past two years, and is hopeful of another income spike once he graduates in August, raising a family in Southern California isn’t cheap. The same is true in South Florida, where they used to live.

Their two boys are both in braces, resulting in orthodontia bills of $350 per month. There is light at the end of the tunnel however, as one son completes treatment this month and the other in August. Their daughter is expected to get braces in 2008.

Playing the game of ‘catch-up’

They have no savings accumulated for emergencies, unplanned expenses, an annual trip to Florida or even the coming summer months when they drop down to one paycheck.

Retirement planning has been another casualty of their high cost of living and tight household budget. Their lone retirement investment is a variable annuity for $6,500. Neither has an IRA and neither contributes to a 403(b) plan through work. Phil doesn’t know if there is an employer match that they are missing out on by not participating. They readily admit they haven’t planned for retirement because, as Stacey puts it, “We’ve constantly been playing catch-up.”

Fortunately they are employed in the public sector, where pensions are still commonplace, provided you put in the time. Due to their job changes when they relocated cross-country, they are starting over from a pension standpoint. Phil’s 14 years teaching in Florida will provide only a minimal pension in retirement.

The burden of future college tuition for their three children has been eased to an extent by one of the grandparents purchasing the Florida prepaid tuition plan for each child. One thing Phil and Stacey must establish is, now that they’ve relocated, how much will the Florida prepaid tuition buy if their children attend college in California. If there is a shortfall, will that be shouldered by them, their kids, Grandma or a combination of the three? Establishing the answers to these questions are necessary for Phil and Stacey’s long-term financial planning.

Phil and Stacey have very cost effective life insurance policies paid on a pretax basis via payroll deduction through Phil’s employer. Stacey’s policy is more than sufficient but Phil’s is short considering their lack of other assets. They have two additional policies, one on Stacey and one on their oldest son, that are not paid for via payroll deduction and have modest cash values accumulated. But the premium for Stacey’s policy is about to go back up.

To add a couple of final points, neither Phil nor Stacey has any disability insurance coverage. They also receive a sizable tax refund each year, and expect the same again this year.

Key issues
  • Monthly mortgage payment and loan balance have increased, while they continue to make only the minimum payment.
  • No liquid savings for emergencies or unplanned expenses.
  • Rely on borrowing to make up the difference between spending and income.
  • Typically pays only the minimum required payment on credit cards.
  • No retirement savings.
  • Insufficient life and disability insurance protection for Phil.

This report was prepared by Bankrate Senior Financial Analyst, Greg McBride, CFA.

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