Surprise: 'Toxic' Mortgages Are the Best for Rational Borrowers

September 23 2007 BusinessWeek.com A new study from professors at Columbia and NYU finds that the "optimal" mortgage in a perfect world is an option ARM. If you had to name the most toxic, dangerous, foolhardy kind of mortgage loan that exists, you'd very likely pick a pay-option ARM, which lets borrowers get deeper into debt by paying less than the minimum interest they owe each month and adding the unpaid interest to the loan principal. The loans have a very high penalty for prepayment so borrowers can't get out of it easily once they're in it. According to a new study by professors from Columbia and New York universities, the "optimal" mortgage in a perfect world is precisely that kind of loan—an adjustable-rate mortgage with an option for negative amortization and a ban (or at least severe restriction) on prepayment. In the real world that we are condemned to inhabit, many people who took out option ARMs foolishly believed that they would never have to pay more than the bare minimum monthly payment. At some point they have hit (or soon will hit) a ceiling on total permissible mortgage debt, at which point the terms change and their monthly payments soar to unaffordable levels. Next step: default and foreclosure.

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