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Which Arm Should You ChooseThe Left or the Right?

Alan recently joined Friendly Investment and Financing Options (FIFO) as a loan officer. FIFO is a national company that specializes in mortgage lending. One of Alan's responsibilities is to increase the amount of mortgages FIFO originates. In a meeting he had with the CEO yesterday, Alan was told about a new mortgage FIFO intends to market. The new mortgage is called an option adjustable rate mortgage, or an option ARM for short, and its most attractive feature is that homeowners can choose to make relatively low monthly payments at the beginning of the mortgage period. However, the payments increase significantly later in the life of the mortgage. In fact, depending on the amount the borrower chooses to pay early (hence, the term "option"), the amounts that must be paid later could be substantialas much as four to five times the payments made in the early years of the mortgage. In many cases, when a homeowner chooses to pay the minimum amount or an amount he or she can afford, the mortgage turns "upside down," which means the amount due on the mortgage grows to an amount that is greater than the value of the house.

The primary benefit of option ARMs to borrowers is that such loans allow those who cannot afford the monthly payments associated with conventional mortgages the opportunity to purchase houses. A borrower with income lower than is needed to qualify for a conventional mortgage can borrow using option ARMs, choose an affordable (lower than conventional) payment in the early years of the mortgage, and then make the higher payments in later years, when their incomes presumably will be higher. Thus, option ARMs permit those who can't afford conventional mortgages to buy houses today that they otherwise couldn't afford until years in the future.

Lenders such as FIFO like selling option ARMs because they can recognize as current revenues the monthly payments that would be required if the loans were conventional mortgages, regardless of the amounts the borrowers opt to pay. In other words, companies can "book" revenues now that will not be collected for a few years.

Unlike most people, including many professionals, Alan understands the complexities of option ARMs. He knows that many borrowers who choose such mortgages will lose their houses three to five years after buying them because the payments increase so significantly after the low-payment option period expires that these borrowers will not be able to afford the new monthly payments. And, although they would like to refinance with conventional mortgages, often these homeowners do not have good enough credit. This scenario is quite disturbing to Alan. He would like to explain to his customers in clear terms the possible pitfalls of option ARMs, but the CEO of FIFO has instructed Alan he should provide only the information required by law and to follow company policy, which states that lending officers should provide basic printed material, give simple advice, and answer questions that might provide negative information only when asked.

Alan has a bad feeling about option ARMs. He knows they are great lending/borrowing tools when used as intended. He is afraid, however, FIFO is more concerned about booking revenues than about the financial well-being of its customers (borrowers).

1. What should Alan do?

2. How would you personally handle this situation if you were Alan?