Option Adjustable Rate Mortgages

Option ARMs, otherwise known as negative amortization loans, are characterized by giving the borrower four different payment options each month. The first payment option is called the minimum payment and is based on an interest rate that can be as low as 1% and is referred to as the start rate. The minimum payment is fixed for the first year and increases 7.5% each year after that. The second payment is an interest only payment and is based on an interest rate that is made up of an index and a margin. The margin remains the same throughout the life of the loan and the index is usually the MTA, LIBOR, COFI, or COSI. When the index and the margin are added together it is referred to as the fully indexed rate. The third payment is based on the fully indexed rate and is a principal and interest payment amortized over 30 years. The fourth payment is also based on the fully indexed rate and is a principal and interest payment amortized over a 15 year term.

Many people are attracted to these loans because of the minimum payment option. People need to realize, however, that if they only make the miniumum payment they are deferring significant interest every month and their loan balance is actually increasing. People should also keep in mind that they will not receive as large of a tax deduction because they are deferring interest (assuming they don't take the standard deduction). You are encouraged to consult your tax advisor to determine how this type of loan will effect your tax situation.

For certain borrowers this loan is an excellent option and for others it can be very dangerous. It works great for borrowers, for instance, that are paid on commision. In slow months, the borrower can make the minimum payment and in more productive months they can make the 30 or 15 year payment. It also works well for financial savy borrowers that take the difference between the minimum payment and the 30 year amortized payment and invest it in safe instruments that yield a return that is higher than the fully indexed rate. On the other hand, this type of loan can be very dangerous if the only way the borrower can afford to make the monthly payments is if they always pay only the minimum payment.

If the deferred interest causes the loan balance to increase to 110-115%, of the initial loan amount, the loan will recast. When this occurs, the lender will take away the payment options and calculate a single payment based on the current interest rate and amortize it over 30 minus the number of years that they have held the loan. For instance, if the borrower has been on the loan for 2 years when the loan recasts the new payment will be calculated based on a 28 year amortization. It is clear to see how this can have drastic negative consequences for borrowers that can only afford the minimum payment.

In addition to the potential recast, there are four other potential negatives associated with option arm loans. The first is the fully indexed interest rate adjusts monthly based on market conditions. The second is the margins charged on these loans tend to be high because of the flexability that is offered. The third is that these loans typically come with 3 year prepayment penalties, which means if you want to sell or refinance within 3 years you will be charged an additional 2-6 months worth of interest depending on the lender. The fourth, and maybe most important, is that as the balance of the loan increases the equity in the house decreases. If house values decrease or stay flat for an exteded period of time, it may be impossible to sell the house for enough to repay the mortgage.