In Praise Of A "Toxic" Loan

The loan with the worst reputation these days may be the pay-option ARM. Monthly payments for this adjustable-rate mortgage go up when interest rates rise. And borrowers can sink deeper into debt because they're permitted to pay less than the minimum interest due each month, with the balance added to the principal. If homeowners hit the maximum they're allowed to borrow, their monthly minimum shoots up, which can force them into default (BW—Sept. 11, 2006).

A new academic study concludes that this most toxic of all mortgages is, in a perfect world, the best. How can that be? Because if borrowers have erratic incomes but perfect self-control, they can make small payments in lean months and catch-up payments in good times. That flexibility lessens the risk of default caused by a hiccup in income, a benefit to both borrowers and lenders.

The authors of the National Bureau of Economic Research working paper, Tomasz Piskorski of Columbia Business School and Alexei Tchistyi of New York University's Stern School of Business, say that rather than banning the loans, as some have advocated, the U.S. should educate consumers about their hazards and how to use them properly. Piskorski calculates that the ARMs' total potential benefit to borrowers and lenders combined is at least $50 billion, so even hefty spending on education would be worthwhile.

The public reaction to the study findings has been mixed. One comment on BusinessWeek.com's Hot Property blog: "Experts shouldn't be promoting this type of product for the general population, even just in theory."

By Peter Coy