We all know how the Housing market started this great Recession. Some of us also know how “Adjustable Rate Mortgages” or ARM’s are seen to be responsible for this situation. However, what are ARM’s and how did they affect homeowners? This is what this article attempts to explain at a high level – in layman’s language.
Welcome to Countrywide Finance – the largest Home Lender in America in 2004. By the summer of that year, the Housing and Mortgage boom had accelerated to phenomenal levels. Everyone you saw around you was involved. The easiest way to get rich was to buy a house, wait for it’s value to appreciate, then refinance the loan and presto – instant cash!!
So, let’s look a little bit closer at how this would work. In normal times, you buy a house that costs 200,000. You take a loan from Countrywide at a rate of 5% for say 20 years, so assuming Simple Interest, you will pay Countrywide 875 per month = (200,000 + (200,000*0.05))/240. In other words, each month you pay them an installment and more of the house becomes yours.
Now comes the Get-Rich-Quick part. Let’s say you are halfway through this process and in 10 years, you have paid Countrywide 875 * 12 *10 = 105000 when you realize that the value of your house has increased dramatically to (say) 300,000 – which is a 50% rise (wow). So, you decide to refinance your mortgage and talk to GU Bank instead.
GU Bank appraises your house, agrees that the value is indeed 300,000 and gives you a loan for the remainder 100,000 under more favorable terms. You pay off the remainder 95000 to Countrywide and use the rest of the money to improve the house by buying that new Plasma HDTV or put in that swimming pool. Since the terms of the new loan are more favorable, you have more money left over each month. If you have a lot more, you could even buy another house (and wait for it’s value to appreciate enough, of course).
This is the cycle that led to the Housing boom in America.
Now look at the the problem that Countrywide had: was, if you are already the largest fish out in the big pond, how will you grow? The answer is that you’ve got to come out with something revolutionary – something that none of your competitors have got. So you put your Marketing and Finance whizkids to work to design exactly that – a new and revolutionary product.
Some months later, the whizkids come back to you with the answer to what you asked them to create – a new revolutionary product called the ARM – which stands for the Adjustable Rate Mortgage. This new revolutionary scheme allowed the house buyer one of four options:
a. The Normal Loan option – Described above where each month the creditor pays a normal monthly installment which remains fixed for the term of the loan. This installment contains both Principal and Interest.
b. The “Fast” option – Which allows the creditor to make larger payments than option a – thus allowing for a “prepayment” of the loan.
c. The “Minimum Payment” option – Which allows the creditor to make a payment of LESS THAN the normal payment. The effect of this is that at the end of the payment period, the creditor owes MORE than what he owed at the beginning of the period.
d. The “Interest only” option – Which allows the creditor to make a payment of only the “interest” on the loan (instead of interest and payment in a). In this case too, the creditor will owe more than what they did before the payment.
Additionally, after a preset time period (usually 2 years), options c and d would “reset” to option a above.
What Countrywide’s sales agents did was to push c and d on most people who could not afford it. In other words, if you earned 2500 a month, options c and d would allow you to go for a house that had an installment of 2000 a month – which you would normally not afford. If you were a sub-prime borrower, this would be even worse.
To add to the misery of home borrowers, the market for houses tanked and went lower and lower. As a result, most people who had chosen c and d in their greed to buy what they could not afford were very badly hit because when their option c and d loans “reset” because their houses were LESSER in value and refinancing was not an option.
As a result, a very large number of home borrowers defaulted on their loans. This led home loan companies to raise their rates making the overall situation even worse and heralding the recession.
Below is an excellent reference on this article if you;d like to read more:
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