Is your Option ARM about to recast?

17 Nov Is your Option ARM about to recast?

Many people who took out adjustable rate mortgages. Many more were suckered into Option ARM loans believing it would be advantageous to have the flexibility to choose each month the payment amount they would pay on their mortgage. A typical Option ARM loan has four or five options – pay nothing, pay an amount less than the amount required to pay principal and interest for that month, a 15 year amortized mortgage payment, or a 30 year amortized mortgage payment. If you chose the first or second option, options the mortgage servicers encouraged you to take, you ended up with negative amortization.

Negative amortization occurs when the monthly loan payment is less than the principal and interest needed to pay off the loan in a specific period of time. The difference is then added to the loan amount so that the borrower owes more than the amount he or she initially borrowed. In order to collect the additional sums added to the loan, the loan is recast or recalculated. Recasting the loan is done to limit the amount of negative amortization and to help keep a mortgage loan on its original schedule to be paid in full (i.e., 15 years, 20 years, 30 years, etc.). Option ARM loans are usually recast every five or ten years – but it could be sooner if your negative amortization limit is reached. What does this mean for the borrower? Usually a huge increase in your mortgage payments.

The recasting or recalculating of your loan is based on three things: (1) the outstanding principal balance at the time the loan is recast, (2) the remaining term of the loan, and (3) the fully indexed rate. When your Option ARM loan is recast, the lender/servicer is determining what payment amount is necessary to fully amortize your loan during the remaining term of the loan. The new amount becomes your new mortgage payment. For example, you took out an Option ARM loan in September 2003 for $150,000 at 5% interest with a monthly P&I payment of $805.25. Every month you paid only the minimum payment required of $550.00. In 2008 your loan recasts to the fully indexed rate of 11.75% interest resulting in a new P&I payment of $1,615.06. What happened?!!!

Because the payments you were paying each month did not fully cover the principal and interest due that month, negative amortization occurred. This then caused your principal balance to increase each month. In the example given, the monthly payments were based on the loan being paid in full in thirty years. However, when the loan was recast in 2008, the loan could only be amortized over twenty-five years – not the thirty years it was originally amortized. Additionally, the principal balance had grown from $150,000 to $160,000 and the interest rate changed from 5% to the fully indexed rate of 11.75%. The result is a substantial increase in the principal and interest payment – usually an amount the borrower can no longer afford to pay.

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Jay S. Fleischman is a bankruptcy lawyer with offices in Los Angeles and New York. He can often be found on Google+ and Twitter, where he shares information about consumer protection issues and personal finance.
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