“Pay-option mortgages” are loans in which homeowners can choose to pay the interest or even just part of the interest on their mortgage each month. If they do this, the unpaid interest is added to the principal resulting in a mortgage that actually grows over time.

These risky (insane!) mortgages are illegal in many states, but that didn’t stop Countrywide from issuing a whole bunch of them anywhere where they could get away with it. BusinessWeek explains in an article from September 11, 2006:

The bill is coming due. Many of the option ARMs taken out in 2004 and 2005 are resetting at much higher payment schedules — often to the astonishment of people who thought the low installments were fixed for at least five years. And because home prices have leveled off, borrowers can’t count on rising equity to bail them out. What’s more, steep penalties prevent them from refinancing. The most diligent home buyers asked enough questions to know that option ARMs can be fraught with risk. But others, caught up in real estate mania, ignored or failed to appreciate the risk.

There was plenty more going on behind the scenes they didn’t know about, either: that their broker was paid more to sell option ARMs than other mortgages; that their lender is allowed to claim the full monthly payment as revenue on its books even when borrowers choose to pay much less; that the loan’s interest rates and up-front fees might not have been set by their bank but rather by a hedge fund; and that they’ll soon be confronted with the choice of coughing up higher payments or coughing up their home. The option ARM is “like the neutron bomb,” says George McCarthy, a housing economist at New York’s Ford Foundation. “It’s going to kill all the people but leave the houses standing.”

Now it looks like these mortgages may have ballooned out of control.

As of the end of December, Countrywide had nearly $29 billion in pay-option loans, with about $26 billion of the total having grown beyond their original loan amount, the company said in a filing late Friday with the Securities and Exchange Commission.

“Our borrowers’ ability to defer portions of the interest accruing on their loans may expose us to increased credit risk,” the company said. It added that its risk could be greater because the amount of deferred interest on pay-option loans was on the upswing.

The Associated Press says that the number of homeowners missing their interest-only payments is still increasing, and a staggering 81% of borrowers with these risky loans provided little or no documentation of their income.

As of the end of December, 71 percent of borrowers with pay-option loans were electing to make less than full interest payments.

Way to go Countrywide… er we mean “Bank of America.”

Countrywide sees pay-option loan risk [BusinessWeek]
(Photo:Meghann Marco)

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