About 40 percent of borrowers with option ARMs are already delinquent, and “many” of the others will start missing payments before their obligations change, the Barclays mortgage- bond analysts wrote in a July 24 report. . . . More than $750 billion of option ARMs were originated between 2004 and 2008[.]
The default rate on subprime loans issued to people who have bad credit is lower.
What is an Option ARM loan?
Option ARMs were typically issued to creditworthy homeowners and allow borrowers to make a range of monthly payments. The payment options include a partial-interest payment that adds the unpaid interest to the loan's balance. On many such loans, balances have risen while values of the underlying properties have plummeted amid the housing crisis.
Eventually, the loans are "recast" but often this right of the bank takes five to ten years to kick in.
To put this in perspective, I have never seen a credit card agreement that has a minimum payment that is lower than the monthly finance charge. Until recently, a common minimum payment on a card was 2.5% of the monthly balance, and the interest rate on the balance was typically 1%-1.5%. The minimum payment on a credit card may reduce the principal amount very slowly if you make no new charges, but it always gets smaller, and at some point, the credit card company generally prohibits you from making more charges rather than allowing it and carding you an over the credit limit fee.
Car loans typically amortize over a time period shorter than the car is likely to function. The vast majority of mortgages are written with an amortization period of up to 30 years, and increasingly, even 40 years (both far less than the useful life of a home). An interest only loan at least keeps the principal balance the same, and then hits the borrower with a balloon payment at the end of the loan.
Allowing the balance to rise, due to accumulating interest, called "negative amortization" was previously very rare.
You would see it now and again during brief promotional periods in connection with car loan deals, where price and finance charges interact fluidly. You have reverse amortization before the payment period begins in a construction loan or a student loan, during a funding period. You have reverse amortization, in a very carefully regulated and intentional fashion, with some consumer safeguards like a non-recourse, no foreclosure term, in reverse mortgages (designed to let elderly people with lots of equity get cash out of their homes without moving out).
But, the only place you commonly see reverse amortization outside the funding period of a loan are in highly abusive payday loans or automobile title loans, for small amounts, with annual percentage rate interest rates of 300% or more. The only reason that these loans get paid at all is because the principal amounts are typically so small.
Generally speaking, negative amortization is a powerful flag that a transaction is unstable, crushing the borrower and likely to default.
There is a very good fundamental mathematical reason for this, indeed the same fundamental mathematical reason that Ponzi schemes always unravel sooner or later. The "miracle" of compound interest for the investor, is an apocalypse of exponential obligations for the borrower. In any situation where interest is paid on interest, the interest amount grows exponentially. Ability to pay, however, very rarely increases exponentially.
The physics analogy to exponential growth is the distance traveled by an object that continually gets faster at the same rate. This doesn't happen even for free falling objects, which eventually reach a terminal velocity, due to friction with the air, or hit the center of gravity. Even in empty space, the very laws of nature, in this case special relativity, prevent this kind of acceleration from taking place indefinitely. Sooner or later, equally increased efforts to increase speed stop translating into increased speed.
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