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Beware the Option ARM Criminals


If a loan officer should try to steer one of your first time home buyer clients toward an Option ARM, grab your first time home buyer by the arm and run away. These loans are highly profitable for the loan officer but almost always work out badly for the borrower. Every first time home buyer I’ve ever seen get into an Option ARM was, within less than one year, was trying as hard as possible to get out of it. Usually they wind up being stuck with the Option ARM because of the big, unnecessary prepayment penalty the loan officer had most likely tricked them into. Why would a loan officer persuade a first time home buyer to take a long prepay penalty on a potentially dangerous loan like an Option ARM? Simple. The 3-year prepayment penalty is how loan officers make the big money with these loans. Here’s how that works: 

Lenders normally package Option ARMs with three choices of prepayment penalty; (1) No prepayment penalty; (2) One year prepayment penalty; and (3) Three years prepayment penalty. The rebate or yield-spread-premium that the lender pays to the loan officer often closely matches the prepayment penalty. An Option ARM with no prepayment penalty probably would not pay any rebate to the loan officer. An Option ARM with a one-year prepayment penalty will often pay one point of rebate to the loan officer. The big money comes when the loan officer can persuade (more like trick) the first time home buyer into accepting a three-year prepayment penalty. In this case, the lenders will often pay three points of rebate or more to the loan officer. 

Why would a first time home buyer agree to a three-year prepayment penalty if this were the worst option? The most common reason is that the loan officer did not provide all the facts. This is often done purposely. The loan officer will simply tell the borrower that a three-year prepayment penalty is the only option that the bank provides. The first time home buyer never finds out about the other possible prepayment penalty options. That would be lying by omission by the loan officer. In other cases, the loan officer will offer to cover all closing costs through the lender rebate, if the borrower chooses the 3-year prepayment penalty. That’s still a horrible deal for the first time home buyer. Within one year after the close, the lost equity that an Option ARM causes from negative amortization will exceed what the closing costs would have been – and the borrower still has two more year of big-time negative amortization until the prepayment penalty expires.  

The worst abuse of this situation occurs by loan officers who work for direct lenders. A loan officer who works for a mortgage brokerage (and would therefore be required to have a real estate license) must disclose the lender rebate to the first time home buyer. A mortgage broker’s final HUD will show that rebate.  This is not the case with a loan officer that works for a direct lender. Direct lenders, sometimes classified as mortgage bankers, are not required to reveal lender rebate in their good faith estimates nor in the final HUD. Some of these loan officers have been known to get the three point rebate and then charge the borrower points of origination as well. They assume that the first time home buyer will never find out about the rebate that they will receive from the lender. In most cases, they are right. There is no required disclosure of that rebate. Imagine that – a loan officer making 4 points (3 points of rebate and 1 point of origination) and stuck the borrower with a 3-year prepayment penalty. Meanwhile the first time home buyer was never told that he had other prepayment penalty options and, worse,  he thought he was paying the 1 point of origination because the loan officer told him that he was not earning any rebate from the lender.

In a nutshell, steer clear of loan officers that advocate Option ARMs. They do not have your first time home buyer clients’ best interests in mind.

































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