When an adjustable-rate mortgage (ARM) resets, it suddenly raises monthly payments. This phenomenon is fueling the foreclosure crisis. As real estate prices fall and home equity vanishes, those who hold volatile and risky ARM and Option ARM loans may find themselves owing more than their houses are actually worth.

Millions of ARM loans will do-or have already done-an "ARM reset," which means that they undergo a scheduled monthly payment adjustment. Because they typically begin with a low teaser rate, they generally go much higher when the ARM reset kicks in, and it's not unusual for monthly mortgage payments to double.

The trouble with Option ARMs

To add to the problem, many of these loans are "option ARMs," which share the risky and exotic characteristics of both ARMs and "negative amortization" loans. Option ARMs offer convenient, but potentially hazardous, monthly options to the borrower. Homeowners can pay principal and interest, interest only, or simply a nominal minimum monthly fee. Nearly two-thirds of those who currently have option ARMS pay less than the full amount each month. But the portion of principal and interest that goes unpaid doesn't just go away-it remains in full force, and can grow as additional interest costs are added to it. After paying for months or years, a homeowner can still owe more than the total amount of his original loan. The option ARM is also subject to the ARM reset phenomenon. That's usually enough, all by itself, to trigger disaster and send homeowners into default.

A loss of home equity

According to recent data supplied by Countrywide Financial, one of the nation's largest mortgage companies, Americans are falling deeper into mortgage debt, as plummeting home values continue to erase home equity. This summer, a survey of loans revealed that the typical borrower owed an amount equal to 95 percent of the value of his home. Most of the trouble can be traced to volatile interest rates, falling equity, and the widespread presence of high-risk ARM or Option ARM loans.

Owing 95 percent of the value of one's home is a recipe for catastrophe. Most mortgage companies in today's crisis-sensitive environment will not even make loans with less than 15 or 20 percent down, because they want to have the added reassurance and financial buffer that the higher equity affords. Owing 95 percent is the same as having only 5 percent equity, and that small amount can be quickly nullified. If the home's value falls just 5 percent, for example, the home equity becomes zero. But even if a homeowner decides to sell to pay off the mortgage, the sales commission paid to a realtor will likely be more than five percent. Selling to pay off the loan may still leave the borrower "upside down" in the loan, with too little in the way of sales proceeds to satisfy the leftover mortgage balance.