The cover story of the latest issue of Business Week Magazine paints a very unflattering picture regarding the housing situation for the millions of Americans who purchased their homes using Option Adjustable Rate Mortgage (ARM) loans. Essentially, an Option ARM allows a home buyer to initially have a much lower monthly payment than if they were to have used a traditional mortgage, thanks to a lower interest rate. In exchange for the lower payment, the ARM will readjust to a higher interest rate, typically in 3, 5, 7 or 10 years.
Now that many of the Option ARMs are readjusting, many home owners face the possibility of not being able to afford their new monthly payment: Many of the Option ARMs taken out in 2004 and 2005 are resetting at much higher payment schedules – often to the astonishment of people who thought the low installments were fixed for at least five years. And because home prices have leveled off, borrowers can’t count on rising equity to bail them out. What’s more, steep penalties prevent them from refinancing. The most diligent home buyers asked enough questions to know that option ARMs can be fraught with risk. But others, caught up in real estate mania, ignored or failed to appreciate the risk. The option ARM is “like the neutron bomb,” says George McCarthy, a housing economist at New York’s Ford Foundation. “It’s going to kill all the people but leave the houses standing.” Unfortunately, while the blame for the potential Option ARM may be shared equally between the borrowers, brokers, lenders and underwriters, it appears that the borrowers/home owners are going to have to carry the lion’s share of the burden.
“Most of the pain will be born by ordinary people. And it’s already happening. More than a fifth of option ARM loans in 2004 and 2005 are upside down – meaning borrowers’ homes are worth less than their debt. If home prices fall 10%, that number would double. The number of houses for sale is tripling in some markets, so people are not going to get out of their debt,” says the Ford Foundation’s McCarthy. “A lot are going to walk.” That’s a pretty scary situation, regardless of how likely it is to come to fruition.
After reading the Business Week article, I took away three very important items:
- ALWAYS perform the necessary due diligence on ANY major purchase. Whether it’s a house, a car, an investment, etc., it is up to you and only you to make sure that you are as informed about all aspects of the purchase as you can possibly be.
- Have an understanding of what you can REALLY afford, not what someone else tells you you can afford. Typically, they are vastly different numbers.
- Always try to have “sizable” amount of money in reserve. I know it’s easier said than done, but having a fallback of even two months salary can make a large difference in your finances.
In wrapping up, bits of news like this illustrate the importance of having the ability to set aside money. Whether you do it thanks to living frugally or just finding ways to spend less than you earn, the fact remains you have to find a way to get it done. Nobody really expects the worst, but it’s not a bad idea to plan for it anyhow.