I read a hilarious article from RisMedia yesterday that still makes me chuckle, titled Adjustable Rate Loan Resets, Skyrocketing Mortgage Payments for Homeowners. It is a quick read.

The beginning of the article offers some good insight into the dangers ahead — dangers that many of my friends and family will be facing, even with my dire warnings for two years:

Many households that took advantage of “teaser rate” loans-types of adjustable rate mortgages that hold down payments for an initial period, are facing resets of their interest rates that can cause monthly payments to balloon upward of 10% to 50% as reported recently by realestatejournal.com. A $1 million mortgage taken out 30 months ago that started at $2,528 per month, could jump to just under $7,000 per month. According to the Mortgage Bankers Association, there are about $1.1 trillion to $1.5 trillion in ARMs that will face rate increases this year.

Yes, folks, that is trillion with a T. There is only one word that comes to my mind when I hear about these resets: oops. You reap what you sow, and if you’re sowing great overwhelming debt, you will reap years of servitude to the mortgage holder.

But that isn’t the funny part — that is the sad part. The funny part comes at the end:

One alternative many of SMR’s clients are seeking is negative amortization loans. Funded properly, this form of financing is a viable alternative for home buyers that need to minimize their monthly payments while shedding themselves of the thousands they will be paying through a mortgage reset.

What SMR is offering is to take the ARM loan — which originally cost just principal plus a teaser interest rate (1%), but then jumps to principal plus a high interest rate (8+%) — and turn it into a negative amortization loan. What this means is that instead of paying principal plus interest, you pay only interest, or only part of the interest, so the loan gets bigger over time. SMR sells this loan probably by telling their customers that their income will go up in the future, so they’ll be able to pay more when it is time to start paying off the principal. Why pay for the principal now with your mediocre income when you can just pay part of the interest, and then really start paying off the loan in the future when you’re wealthier and earn more? They might also sell it by explaining that the housing market is in a temporary decline, but eventually housing prices “always go up” so once the decline is over, your house will be worth more than the negative-amortization loan will cost to pay off.

Let’s look at a typical $250,000 home loan under an ARM with a teaser rate of 1%. In the first 2 years, your mortgage payment is $804.00 per month — nice! But the ARM will eventually reset to the current rate. After 2 years, if the current interest rate is 8%, your mortgage then jumps to $1758, assuming you only paid $804 per month for 2 years to bring your principal balance down to $235,500.00 at the time of reset. Basically, your mortgage payment will double after 2 years (approximately), and this does not consider property taxes, insurance or association dues. For many households, that doubling is not just unexpected, but painful if their housing market is in a decline and they can’t refinance to attempt to reduce payments again. Even worse, many teaser rate loans have prepayment penalties in the tens of thousands, making it impossible to refinance as their homes might be worth less than their current mortgage, not including refinancing with the penalties in place.

The negative amortization loan may seem to be the only option — why not refinance the new principal ($235,500) plus the prepayment penalities ($11,775) into a new negative amortization loan ($247,275)? Your payment would drop to “only” $632.

The problem with this situation is that you are now a speculator — just like someone buying stocks on margin (paying an interest rate for a loan to buy stocks in hopes that they will appreciate more than the interest rate you’re paying). If your speculations fail, you will be so far upside down on your mortgage that you may never get ahead. Even worse, many banks will put a cap on how far your can negatively amortize your loan — if you hit that cap, they will automatically force you to make positive-amortization payments that will be signfiicantly more than if you just paid your reset-rate originally. Remember, with a negative-amortization loan, your principal is never paid, but instead it is tacked on to your “payoff” mortgage amount. Your balance grows each month, and you’re speculating on a variety of hopeful outcomes:

1. Your income grows signficantly, enough to make a real mortgage payment,
2. Your house value grows significantly, enough to cover paying off your mortgage,
3. Your taxes and insurance don’t go up signficantly.

These are very unrealistic and, in fact, dangerous to speculate on.

My solution to the problem is the best there is — get out. Get out now! In many cases, you will have to bring cash to the closing to pay off the remainder of your loan plus penalties, but at least you’ll get out. If you have a good credit score, you can finance the shortfall with a signature loan or a loan against other assets. If you can’t do that, why would you even consider getting yourself into hotter water? Most real estate experts will tell you that there’s a frying pan, and there is a fire. I’m giving you another solution: get off the stove until you can really handle cooking your meal.

Discuss this article at the housing bubble forum.