Prime mortgage option ARMs showing signs of trouble

Option ARMs -- I call these the upside-down mortgages -- are now showing signs of weakness according to the Wall Street Journal today. The Journal reports that 3.55% of option ARMs originated by Countrywide (NYSE: CFC) are at least 60 days late. The problem could grow dramatically between 2009 and 2011, when monthly payments on $229 billion of option ARMs will be adjusted to market-rate interest and principal.

These mortgages start with a teaser rate well below the market rate and then allow payments that don't even cover all the interest charges. Of course, no principal is paid either. Instead the unpaid interest is added to the principal of the loan - hence my nickname the upside-down mortgage. It's much like an upside-down car loan. Your mortgage principal quickly becomes higher than the price at which you can sell your home. During the meteoric rise in house prices when the housing bubble was inflating, this was no big deal. But now that housing prices are dropping, many people will be stuck with mortgage principals higher than the market value of their home and they won't be able to refinance when the loan resets to market rates. They also won't be able to sell their home without coming up with cash at closing.

You've probably seen this type of loan advertised on TV or the Internet where the consumer is promised a ridiculously low payment of $300 or $500 a month on a $200,000 mortgage loan. Or when the lender says borrowers can pick their payments each month. Yes, they're giving borrowers options, but none of them are financially sound -- except for the immediate satisfaction of a low loan payment for a couple of years. These are a sure road to financial disaster. I wonder why it's taken so long for someone to notice?

Lita Epstein has written more than 20 books including "The 250 Questions You Should Ask to Avoid Foreclosure" and the "Complete idiot's Guide to Improving Your Credit Score" due out in December.