Forewarned is fore-ARMed

November 18, 2007|By Marilyn Kennedy Melia

Lots of people blame the spate of foreclosures on the "exotic" mortgages made in the housing boom.

The "interest-only option ARM" ranks among the most exotic of the bunch -- and probably the most "toxic" too. In fact, many companies have stopped making this loan because too many borrowers have defaulted on it.

But two economists -- Tomasz Piskorski of Columbia University and Alexei Tchistyi of New York University -- have conducted a study showing that the interest-only adjustable-rate mortgage can save borrowers money -- if it's used correctly.

In a National Bureau of Economic Research working paper, the economists provide an intricate argument as to why.

Basically, the mortgage is offered at a low, introductory interest rate. But instead of paying the minimum, borrowers should pay as much as possible in that low-rate period, says Piskorski.

By devoting all or nearly all of their discretionary income to their payments, they're whittling down the principal. When the interest rate does adjust up, the amount due won't be as high as it could be because the interest is figured on a smaller balance.

As the years pass, homeowners can use the extra income for other purposes, taking a break from diligently paying down the balance.

But many option-ARM customers have done just the opposite. They have paid a bare minimum -- not enough to cover even all the interest. So their balance grew, sometimes to more than they could sell the home for, resulting in foreclosures.

Piskorski hopes that if customers were required to receive training before taking one of these loans, they'd learn to maximize the interest savings an option ARM can provide.

Whether human nature can be directed into such rational budgeting behavior is a question, however.