Option ARM - Option Adjustable Rate Mortgage

Option ARMs: The Fanfare and the Facts

Optional-Payment Adjustable Rate Mortgages, or Option ARMs, are the flashy and increasingly popular option in home payments. Super low payments and plenty of flexibility are irresistible to many homeowners looking for more home and less fuss.

But Option ARMs are actually some of the most complex, and in many cases misleading, mortgages around today. In fact, a recent cover story in BusinessWeek named this program “nightmare mortgages,” “toxic,” and even “deceptive.”

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ERATE was warning the public about the dangers of Option ARMS back in 2005.

Here is a quote from Bloomberg / Business Week made by Keith Schemm representing ERATE.

Be especially cautious of markets in which option adjustable-rate mortgages are hot. These loans offer borrowers extremely low teaser rates -- typically, just 1% for the first month -- and allow the option of making a minimum payment that may not even cover all of the interest owed for the month. The unpaid interest gets added to the principal, so the total owed can swell like a credit-card bill. Borrowers may be enticed by the introductory rate but unprepared for later payments on the swollen principal. Keith M. Schemm, a mortgage broker in Santa Clara, Calif., says option ARMs are "pretty dangerous loans to do" for many families. "The problem is there's such a frenzy in the marketplace to buy a home."

To truly feel the benefit of Option ARMs, and avoid the substantial risks, borrowers need to be up to speed on the often-overlooked rules and procedures.

With Option ARMs, there are usually several choices of payments each month:

  • Traditional payments of principal and interest. Payments are based on a set loan term of 15 or 30 years, and payments reduce the amount you owe on your mortgage.
  • Interest-only Payments. With this option you pay interest each month, with the option of paying more with additional income (bonuses, etc.). The amount of principal is not reduced if you pay just interest.
  • Minimum or Limited Payments. Usually this option may be less than the amount of interest due that month. If you choose this option, the amount of interest you do not pay is added to the principal.

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In addition to choices on monthly payments, Option ARMs often feature a very attractive and very low initial interest rate. This rate can be as low as 2 percent for the first few months. In some cases the initial rates is good for only the first month!

Now comes the fine print. What many borrowers do not realize are the significant risks of optional payments and the introductory interest rate. Let's take a look.

  • Interest rate: While the low-low rate sounds amazing, it is very short lived. Often this rate only applies for a month or two. After this time, the interest rate rises to a rate similar to other loans.
  • Monthly Payment Drawbacks: If you opt for the monthly minimum or limited payments option, the billed amount is based on the initial low interest rate. When rates rise after the first few months, the minimum payment you're charged may not cover all the interest you owe, or any of the principal. Any unpaid interest is added to the principal. This means an increased amount that you ultimately owe. It also means increased interest over the life of the loan, and increased future monthly payments. This ugly phenomenon is called negative amortization.
  • Option ARMs have a built-in recalculation period. Often this occurs at the five-year mark. Your loan will be recalculated based on the remaining term of the loan. If you have been paying minimum payments, or if interest rates have risen faster than your payments, your loan balance has probably increased instead of lowered. Now you have to pay a larger amount over a smaller time period. Also, you don't have the option to only pay interest or minimum payments. Instead, you must pay interest and principal, and your monthly payments may rise significantly. Alternatively, this recalculation could occur before the five-year mark if your principal has grown beyond a set limit. Get ready for payment shock even earlier in this case.

Are Option ARMs actually good for anyone? For some people, they are the perfect fit. Borrowers with irregular income (such as commissions, seasonal earnings, or bonuses) can use optional payments to pay little when they have small income, and larger payments when they are flush with cash. In addition, borrowers with modest income now, but who expect to see income increase in the future, can use Option ARMs to buy for now and pay later.

Option ARMs are not recommended for borrowers who do not understand the complexities of the loan, or who receive regular, unchanging income.

To learn more about Option ARMs, visit the Federal Reserve Board's site: “Interest-Only Mortgage Payments and Payment-Option ARMs: Are they for you?”


Example of one lenders Option ARM Program
Option ARM Program puts you in control of your home loan. This is how it works: Each month, you will receive an easy to read loan statement that lets you choose the payment amount that best suits your current financial needs. Pay the minimum amount to free up funds for other uses, or make larger payments for faster equity build up.

Loan Features:
  • A fixed interest rate for an initial 1-month period; thereafter the interest rate may change monthly
  • A minimum payment amount that adjusts on an annual basis subject to a 7.5% payment change cap
  • A 7.5% payment change cap limits how much the minimum monthly payment can increase or decrease from the previous minimum payment, except on the fifth year of your loan and every five years thereafter*
  • A lifetime interest rate cap that protects you by limiting how high your interest rate can go
(During the initial interest rate period, Option 1 represents a full principal and interest payment; therefore, Options 2 and 3 are not applicable.)
Option 1: Minimum Payment Due
This option gives you more cash now and keeps your monthly payments manageable
  • Payment changes annually and is calculated using the initial interest rate for the first 12 months
  • The minimum monthly payment is usually recalculated annually thereafter; and is based on the outstanding principal balance, remaining loan term and prevailing interest rate
  • 7.5% Payment Change Cap limits how much this option payment can increase or decrease each year
(During the initial interest rate period, Option 1 represents a full principal and interest payment; therefore, Options 2 and 3 are not applicable.)
Interest Only Payment
At those times when the minimum monthly payment is not sufficient to pay the monthly interest due, you can avoid deferred interest by paying the minimum monthly payment plus any additional interest accrued during the month.
  • Payments remain manageable, with no change in your principal balance for that month
(Option 2 will not be offered if the interest only payment is less than the minimum payment due.)
Option 3: 30-Year Full Principal and Interest Payment
This is the fully amortized payment based on a 30-year loan.
  • Calculated each month based on the prior month's interest rate, loan balance and remaining loan term
  • Pays all of the interest due and reduces your principal, to pay off your loan on schedule
(Option 3 will not be offered if the full principal and interest payment is less than the minimum payment due.)
Option 4: 15-Year Full Principal and Interest Payment
For faster equity build-up, quicker payoff and substantial interest savings, choose the largest monthly payment option.
  • Calculated to amortize your loan based on a 15-year term from the first payment due date
(Option 4 will be offered only on the 30 or 40-year term and will cease to be a option when the loan has been paid to its 16th year.)

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