Lesson 18 of 25 · 7 min
Payment shock on option ARMs, 2007
An option-ARM recast is an ordinary reset on a principal that grew, and the jump is arithmetic.
Option adjustable-rate mortgages originated in the mid-2000s are a widely reported public episode. The product offered a choice among payment options, including a low introductory payment that did not cover full amortization. Unpaid interest joined the principal. A recast around year five then restated the loan as fully amortizing on whatever principal then existed. The years 2007 and 2008 were when many of those recasts arrived, and they arrived as rates had risen. The sequence, not a villain, is the lesson: a payment that was a choice among options, a recast to fully amortizing, a payment that jumped.
Widely reported at the time was that the introductory option could be smaller than the interest accruing, so the balance grew, and that the recast replaced the option with a fully amortizing installment on the larger principal at the then-prevailing rate. Track 12 lesson 7 is an ARM's reset cadence. Track 5 lesson 12 is a capitalizing balance. An option-ARM recast is those two machines on one household loan: the rate's calendar, and a principal that had been allowed to grow.
No lender is named as the cause. No individual is named. The product is the episode. A payment that had been an option became a required fully amortizing figure, and the gap between those two figures is what 2007 made visible in large numbers. The jump is arithmetic on a recast principal. It is not a recommendation about any mortgage.
The sequence is an option payment, a growing principal, a recast to fully amortizing. 2007 is when many of those recasts arrived. The entity at the center is the product, not a person.
Key terms
- Option ARM
- An adjustable mortgage that offered a choice of payments, including one that did not cover full amortization. A widely reported mid-2000s product.
- Recast
- A restatement of the loan as fully amortizing on the then-remaining principal, commonly around year five on these products.
- Payment shock
- The jump from the option payment to the recast installment. Arithmetic on a larger P at a reset rate.
Worked example
A recast on $312,000 remaining
Illustrative figures scaled down so the arithmetic is followable; they are not the reported amounts. Remaining $312,000, 6.85 percent, 300 months after recast. Option payment had been $1,142.00.
- Remaining principal at recast
- $312,000
- Rate and remaining term
- 6.85%, 300 months
- New fully amortizing PI
- $2,175.39
- Prior option payment
- $1,142.00
- Jump
- $1,033.39
Larger than origination if interest had capitalized.
PMT($312,000, 0.0685, 300).
$2,175.39 − $1,142.00, or 90.5 percent.
The recast printed $2,175.39 against an option payment of $1,142.00. The jump is $1,033.39, 90.5 percent, on a principal that had been allowed to grow.
Check yourself
An invented option ARM recasts on $312,000 remaining at 6.85 percent for 300 months. The option payment had been $1,142.00. What is the new PI, what is the jump in dollars and percent, and what two machines produced it?
An option-ARM recast is an ARM reset with a principal that grew, Track 12 lesson 7's cadence plus Track 5 lesson 12's capitalizing balance. Open Reset cadence: the question that decides a rising month →
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Educational only. Nothing in this lesson is investment, legal or tax advice, or a recommendation to enter into any transaction. Figures are illustrative and computed from the inputs stated in the lesson.