Option ARMs are scary because monthly payments can stay low for a long time and then suddenly go kerflooey. (Did I spell kerflooey right?)

Standard & Poor's is out today with a press release about a report that explains why they tightened up their criteria for option ARMs, effective Aug 1. The report (which is available under Ratings Criteria on the S&P website, fifth item down) explains why S&P felt it necessary to assume higher foreclosure frequencies on option ARMs.

With an option ARM, you have the option to make a minimum payment that doesn't even cover all the interest you owe, let alone any of the principal. The unpaid interest gets added to the balance on the loan.

Annual caps on how much your payment can go up--typically 7.5%--give a false sense of security. The caps are like keeping your thumb over the mouth of a bottle while vigorously shaking it. Eventually, if you underpay what you owe for long enough, the principal on your loan will breach a preset limit, which tends to be either 10% or 25% greater than the original amount borrowed. At that point, all caps are blown off and the monthly payment jumps all the way up to whatever is required to fully amortize the loan over its remaining life.

Example given by S&P: The monthly payment goes up between month 48 and month 49 by 88%. On a $500,000 loan, using S&P's assumptions and my multiplying skills from fifth grade, that would be as follows:

Month 1: $1,665
Month 48: $2,070
Month 49: $3,900

"Payment shock" is what S&P calls this. Here's an understated quote from the S&P analysts:

... some of the borrowers may not have the financial wherewithal or the financial savvy to absorb or plan for sudden jumps in monthly payments.

Correct. Are mortgage brokers and lenders making the risks crystal-clear to all the people who are signing up for option ARMs because they're attracted by that low, low initial payment?

Before it's here, it's on the Bloomberg Terminal. LEARN MORE